Emotions aren’t an investor’s best friend as they can lead to human biases (instinctive and irrational behaviours) which could hurt your investments. Amongst the most common biases experienced by investors is home bias. Here’s what you need to know about it.
What is home bias?
Home bias exists when investors favour investments like shares and bonds coming from their home market. For instance, a British investor suffering from home bias would invest primarily in UK bonds, or shares, such as those in the FTSE-100.
Why do we suffer from home bias?
Early literature, Cooper and Kaplanis 1994, highlights several intuitive reasons for home market bias.
- Currency risk: buying investments in overseas markets usually means holding investments in a foreign currency. When the exchange rate of the Pound and the foreign currency moves up and down, this will affect the overall return of your investment. This creates more uncertainty which investors try to avoid.
- Higher transaction costs: buying overseas can include further costs to access foreign markets that are not applicable to domestic markets. Paying more for something when there is a cheaper alternative can be a difficult pill to swallow.
- Lower informational availability: it can be difficult to source research on foreign companies especially smaller ones in markets that you want to invest in. A lack of information when making an important decision, like where to invest, naturally puts investors off.
- Over optimism: there can be excess enthusiasm surrounding expected domestic equity market returns. While it is natural to prefer what we know and rate it more favourably than we would if it were not familiar, investors can benefit from any unfairly perceived uncertainty. This preference for domestic markets can sometimes be compounded by a level of policy discrimination against holding foreign investment via different dividend withholding taxes treatments. Also, dividend withholding taxes can be seen as another cost that is off-putting when not relevant in domestic markets.
However, these reasons have been largely dismissed by research, technological progress and greater international cooperation.
This is because home bias also rests heavily on various behavioural bias including:
- Illusion of control: the fact investors think they have any influence in their investing success and overlook factors they have no control over.
- Familiarity bias: when investors favour what they know rather than opting for assets they’ve never held before.
- Endowment effect: when investors stick to one type of asset because they are reluctant to change their habits.
How home bias can hurt your investments
Home bias can have an unfavourable effect on your investment portfolio in many ways:
- It’s more risky. You focus solely on investments from your home country, this means you’re taking greater risks since you could underperform if you put all your eggs in one basket and your domestic markets don’t perform as well as other regions worldwide. A better option when building an investment plan and a great way to reduce risk, can be to spread your money across a mix of assets and regions. Also, known as diversification.
- There’s a bigger tie between your personal situation and your investment portfolio. If the UK’s facing a difficult economic climate and your portfolio has a home bias it may suffer a decline, at the same time facing personal challenges due to a weaker economy.
- You could be missing out. There are overseas opportunities that may be generating superior returns to your domestic markets. If you don’t consider them, you won’t experience those returns.
- Too much focus on a couple of sectors. The UK market is more skewed towards the finance and energy sector than other regions, meaning your fortunes are closely tied to those sectors. A global portfolio can help lessen this concentration (as shown in the table below).
Table 1: Sector exposure of major regional indices
|
|
FTSE-100 |
S&P500 |
Nikkei |
Eurostoxx 600 |
Average |
|
Energy |
17.2% |
6.1% |
0.6% |
7.9% |
8.0% |
|
Consumer Staples |
15.8% |
6.7% |
10.5% |
10.6% |
10.9% |
|
Financials |
19.5% |
13.6% |
2.7% |
18.5% |
13.6% |
|
Materials |
10.3% |
2.5% |
7.3% |
7.4% |
6.9% |
|
Utilities |
2.8% |
2.8% |
0.2% |
4.0% |
2.5% |
|
Telecommunications |
3.3% |
2.0% |
8.2% |
4.4% |
4.5% |
|
Health Care |
10.5% |
15.0% |
11.4% |
10.4% |
11.8% |
|
Consumer Discretionary |
9.0% |
13.1% |
20.6% |
12.7% |
13.9% |
|
Real Estate |
1.0% |
2.6% |
2.1% |
1.0% |
1.7% |
|
Industrials |
8.9% |
9.8% |
20.9% |
13.0% |
13.2% |
|
Information Technology |
1.3% |
25.9% |
15.5% |
10.3% |
13.3% |
|
Not Classified |
0.4% |
0.0% |
0.0% |
0.0% |
0.1% |
Source Bloomberg, as of 28 September 2018
*NB. Figures may not sum to 100% due to rounding.
How to avoid home bias
When investing, it’s generally a good idea to spread your money across assets and regions by picking a large range of investments from different markets (not only the domestic one!), so your risk is reduced.However, diversification doesn’t mean you should invest in every single asset and market. At Wealthify, for instance, the diversification of your portfolio is ensured, but we only invest in what our investment managers believe is appropriate. At present we do not have an allocation to Japanese Corporate Bonds as we see more favourable opportunities in other corporate bond markets. Similarly, we are positive on Japan as an investment case, but our analysis suggests Japanese shares provide a better risk-reward payoff for investment in Japan.
Please remember the value of your investments can go down as well as up, and you could get back less than invested. At views as of publishing date.
