Patriotism may be an integral part of U.S. society, but patriotic investing can quickly lead to excessive risk-taking and missed opportunities. International investors call type of favoritism the “home country bias” and it can have a very negative impact on a portfolio. In this article, we’ll take a look at how to recognize and avoid the home country bias.
Reasons for Home Country Bias
There are many reasons that individual U.S. investors tend to be overweight in U.S. stocks and bonds, but these tendencies carry forward to even U.S. investment managers that exhibit a strong preference for local firms that produce non-tradable goods. Economists refer to this confusing tendency to hold only modest amounts of foreign equity – particularly on the part of investment managers that should know better – the “equity home bias puzzle”.
Here are some of the most common reasons that individuals exhibit this bias:
- Employer Stock. Employers often provide incentives for employees to invest in their company, which tends to lead to an oversized position in a portfolio. For instance, a 2001 study found that Coca-Cola employees invested 76% of their discretionary retirement contributes in Coca-Cola shares and only 16% thought it risky.
- Familiarity. Many investors are taught to invest in what they know, which is generally good advice, as long as it leads to a diversified portfolio. But, a 2008 study found that the average U.S. investor held about 70% of their portfolio in domestic stocks, even though the U.S. accounts for just 43% of the world’s stock market value.
Economists have also come up with a couple technical reasons for the home bias:
- Information Access. Domestic companies report to the U.S. Securities and Exchange Commission (“SEC”) and all information is readily available to investors. However, the same information can be more difficult to access for foreign equities, particularly those that trade in emerging markets or other less developed markets.
- Double Taxation. The U.S. Internal Revenue Service (“IRS”) taxes all investments in U.S. domestic companies. However, many foreign equities may be subject to double taxation, since both the IRS and the foreign tax office may demand payment.
Problems with Home Country Bias
Investors might ask themselves: What’s the problem with a home country bias? After all, Warren Buffett and other money managers have made a fortune investing primarily in U.S.-based companies that they know and understand. U.S. companies also tend to be a lot less volatile and risky than other companies in the oft-troubled eurozone or volatile emerging markets like China that have been rocked by instances of fraud.
There are two notable issues to consider:
- Diversification of Risk. U.S. markets have become increasingly correlated due to the advent of exchange-traded funds (“ETFs”) and high frequency trading (“HFT”). For example, Goldman Sachs found that small-cap stocks can be 80% to 90% correlated, while sectors have also seen correlations jump to 70%. As a result, it’s becoming more difficult for investors to diversify risk and increase risk-adjusted returns.
- Missed Opportunities. The U.S. is considered a “developed country” by economists, which means that its growth rate tends to be between 1% and 4% per year. By comparison, developing countries and emerging markets can grow between 5% and 10% per year, creating a significant opportunity for investors to profit from companies operating there.
Avoiding the Home Country Bias
The best way to avoid the home country bias is to invest in a diverse basket of global stocks by either purchasing international ETFs, American Depository Receipts (“ADRs”) or foreign stocks. After all, the U.S.’s portion of the global market has been cut from 90% in 1945 to just 43% today, meaning that an equally weighted portfolio would have less than half domestic holdings, and the foreign exposure should be well diversified itself across multiple markets.
Most financial advisors recommend between 15% and 25% exposure to foreign markets, although this number should increase as the U.S. loses its dominance. Investors can start by purchasing international ETFs, such as the Vanguard FTSE All-World ex-U.S. Index Fund (NYSE: VEU), which invests in non-U.S. equities around the world. With built-in diversification, these international ETFs make diversification easy until investors are more comfortable.