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Diversification

Home (Bias), Sweet Home (Bias)

One of the most common mistakes individual investors make is over-weighting their portfolio which is “close to home”. It’s impressive how consistent that can be.

Articles by Dan Egan

By Dan Egan
Managing Director of Behavioral Finance & Investing, Betterment  |  Published: January 16, 2013

It’s a general principal of wealth management that you should try to diversify risk away as much as possible. A very straightforward example is that if you work for a specific company (say, Enron), you should actually underweight Enron stock in your portfolio, along with other companies like Enron. This becomes apparent when there’s a generalized downturn in an industry, and employees lose both their jobs, and their wealth. Smart investors actually hedge away (or buy something like a put option) on their own company to reduce this risk.

Globally, individual investors are far more likely to have the vast majority of equity in their own country. In the tiny Philippines, with 0.1% of the markets global equity portfolio, individual investors hold 99.5% of their portfolios in Phillipino companies. In the UK, with 7.3% of global equity market capitalization, individual investors hold 65% of their portfolios in UK companies. And here in the US where we have 40% of the world’s equity capitalization we tend to have twice that – 82% – in domestic equity. And this is definitely sub-optimal.[1] The degree of home bias has not yet been explained by any good normative reason yet. Currency risk, better information, or capital immobility can’t actually solve this riddle.

Home Bias in International Portfolios
Home Bias in International Portfolios

What’s funny is that this same bias appears on even a more local level.  The preference for investing “close to home” also applies to domestic stocks. U.S. investment managers strongly overweight locally headquartered firms in their portfolios – particularly small, highly leveraged firms that produce nontradable goods.[2]

So why do we overweight our own countries’ portfolios? It makes us feel good to invest close to home. We know the company names, are comfortable with them, and (feel like…) we have more information about them. Countries characterized by higher uncertainty avoidance behavior display greater home bias and are less diversified in their foreign holdings. Portfolios from countries with higher levels of long- term orientation display lower levels of home bias.[3]

So what should you do?

Invest in a simple international segment of your portfolio (like Betterment does), possibly a bit overweight non-US equities if you are a US investor. But keep it simple, diversified and long-term – many behavioral biases are likely to be worse with companies you’re less familiar with.

[1] All data from Sercu, P. and Vanpee, R. (2007). Home Bias in International Equity Portfolios: a Review. Working Paper.

[2] Coval, J. D., & Moskowitz, T. J. (1999). Home Bias at Home: Local Equity Preference in Domestic Portfolios. Journal of Finance, 54(6), 2045-2073. Blackwell Publishing for the American Finance Association

[3] Anderson, C. W., Fedenia, M., Hirschey, M., & Skiba, H. (2011). Cultural influences on home bias and international diversification by institutional investors. Journal of Banking & Finance35(4), 916-934

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