The tendency of investors to favor investing in domestic, as opposed to foreign, stocks
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Home bias, which might more appropriately be termed home country bias, refers to the tendency of equity investors to favor investing in domestic stocks over investing in the stocks of foreign companies. The overwhelming majority of investors exhibit a high degree of home bias, which can be seen in the high percentage of domestic stocks that comprise their equity portfolio.
Home bias is used to describe the tendency of investors to favor investing in domestic, as opposed to foreign, stocks.
Home bias is important, as it may affect both risk and profit potential for investors.
Of the several factors that contribute to home bias, the strongest is familiarity – investors just feel more comfortable trading the stocks of the companies they are most familiar with.
Why is Home Bias Significant?
Home bias is a significant factor in equity investing because it affects how well-diversified an investor’s stock portfolio is. Investments in foreign equities offer an easy means of further diversifying your investment portfolio.
Foreign equities may also offer extra risk protection against the systemic risk inherent solely in one’s own country – in other words, the risk that an economic and/or financial market downturn may occur that is specific and limited to your home country and unlikely to significantly affect either the economies or financial markets of other countries.
In addition to the risk protection derived from diversifying your investments globally, investments in foreign equities also offer additional profit opportunities. For example, many American, Canadian, and European investors enjoyed sizeable profits in the past from equity investments in major Chinese companies, such as Alibaba Group (NYSE: BABA) and the multinational conglomerate, Tencent Holdings (OTCMKTS: TCEHY). In fact, Tencent is one of the companies often mentioned in discussions of the question, “If you could only invest in one stock, what would it be?”
One fact that argues for putting some effort into overcoming one’s home bias is the fact that studies of the equity markets in major developed nations find that no single country’s contained the best-performing equity investments for more than two years in a row over the past 25 years.
Why Does Home Bias Exist?
Economists and financial analysts are frequently somewhat puzzled, not so much by the mere existence of home bias, but rather by how strong it remains even as globalization renders world markets more and more interconnected.
A bit of home bias among investors living in either the United States or China is to be expected, as these two countries are home to the world’s two largest economies. It only makes sense for investors to favor investing in companies operating in the countries that are perceived to demonstrate the strongest economic standing.
However, home bias is equally strong in countries that are decidedly not among the world’s strongest economies. It is just as present in emerging market nations as in developed countries, and within developed countries, it is just as present in countries like Norway or Sweden, which are not particularly considered to be economic powerhouses.
But even in the countries acknowledged as the preeminent economic and financial centers of the world, the extent of home bias is remarkable. As noted above, the United States is home to just a bit more than half of the world’s traded equities, in terms of market capitalization. Therefore, it would seem that a stock portfolio that is appropriately internationally diversified would not have much more than half its total asset value invested in US stocks.
However, studies of the portfolios of US investors show that most of them place 70%-80% or more of their equity investments in domestic stocks – and many investors maintain an equity portfolio that consists solely of domestic investments.
The Factors Influencing Equity Bias
So, what is it that drives home bias and makes it such a strong force?
The primary factor seems to be familiarity. Regardless of how valid their concern may be, investors tend to believe that they suffer from information asymmetry concerning foreign-based companies – that is, that they just don’t know as much about most foreign companies as they do about domestic companies.
Portfolio managers who invest in foreign equities do incur extra expenses in order to adequately research foreign firms and to stay on top of what’s happening in various foreign markets. In the case of some countries, such as communist China, for example, there may also be legitimate concerns about the transparency and reliability of financial reporting.
To avoid overcomplicating the matter, the easiest explanation is that the vast majority of investors simply feel more comfortable investing in companies that they are more familiar with. They are obviously, generally speaking, more familiar with companies headquartered in their own country, compared to companies whose home country is located somewhere overseas. National loyalty may also be a part of the equation, as investors may have a desire to support domestic businesses.
2. Increased transaction costs
Another factor supporting home bias is that of increased transaction costs. Investors in the U.S. enjoy the advantage of trading, overall, the most widely-traded equities in the world, which means the trading is more liquid, which in turn translates into lower bid and ask spreads.
In addition, some foreign stock markets impose a tax on equity transactions. However, transaction costs are not as high a concern as was the case in the past, as investors can now easily access international stocks by investing in domestic ETFs, which are investment vehicles noteworthy for their low transaction costs.
3. Foreign currency exchange risk
Investing in foreign equities necessarily involves foreign currency exchange risk. It doesn’t just add another area of risk that must be taken into consideration and managed. It also tends to increase total portfolio volatility.
It is another area where investors question whether they possess adequate knowledge, and they tend to shy away from making foreign investments if they think (although erroneously) that doing so will require them to master trading the forex market.
4. Political risks
Finally, investors shy away from investing in companies headquartered or primarily operating in certain countries due to perceived political risks. Potential problems such as asset seizure or the nationalization of companies are the kind of real-world risks that make investors wary of investing in foreign stocks.
Investors would do well to be aware of the tendency toward home bias and, with that in mind, may want to discuss with their financial advisor the prospect of further diversifying their equity portfolio with the inclusion of some well-chosen stocks of foreign companies.
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