Common Investor Mistake No. 1: The Home Bias Trap

Manilla.com

Huw Aaron

Huw Aaron

 

Home bias is an invisible scourge of small investors. It’s a common investing mistake people don’t know they’re making because they don’t know about better options, and have trouble keeping track of their investments.

What is home bias? It’s concentrating your investments in the country where you live, instead of spreading them out over several, relatively uncorrelated economies.

“Investors display a persistent and significant home bias, regardless of domicile, which often conflicts with the tenets of broad global diversification,” Vanguard researchers, led by Christopher B. Philips, said in a 2012 report. “For many investors, foreign securities play an important diversification role.”

Fidelity Investments put out a report last year showing that, while home bias has decreased in the U.S., United Kingdom and Australia over the past decade, it’s still a major problem. U.S. investors tend to keep about 72 percent of their investments in their home market, and about a third of them are significantly overexposed, the report showed.

While home bias is widely recognized by investment professionals as harmful, the real question is “how bad is it for you?”

The better your home country is doing, the less home bias seems to matter. But when your home economy is vulnerable, home bias will affect you deeply. Many Asian stocks weathered the 2008 financial crisis just fine as China’s GDP continued to grow by at least seven percent per year. But a lot of Americans missed that opportunity, and became significantly poorer because of large banks’ mortgage debacle.

Investors are hit by home bias for lots of reasons. They know their home country better than others, and that knowledge makes them feel more secure about investing in domestic companies.

“Investors generally feel more comfortable with their home market and allocate investments accordingly, even if it results in a poorer risk-return trade-off for their portfolio,” the Vanguard researchers reported.

Reading local news makes them more aware of local companies than foreign ones, which means they are quicker to spot opportunities close to home and more optimistic about their home economy in general. Finally, investing in domestic equities is a way to hedge against the domestic inflation rates, which foreign securities won’t do as well.

Just to be clear: If international investing seemed easy, more people would do it. When investors are confronted with choices they don’t understand, they make bad ones.

They may think they need to understand geopolitical trends, exchange-traded funds (ETFs), American Depository Receipts (ADRs), which foreign companies use to list in the United States, or the accounting standards of a foreign country. All of those are prohibitive to diversifying outside of one’s home economy. You could say most investors are trapped in their home countries’ stocks and don’t know how to escape.

While these are all understandable reasons, they do not lead investors to the safest, best long-term returns. Home bias is another way of saying that investors tend to put all their eggs in one basket. Maybe they think that by investing in stocks across several industries, they have diversified their risk.

Home bias fits into the broader trend of people investing in what they know. Tech people put far too much money in tech stocks. They suffered disproportionately when the dot-com bubble burst. That same pattern is happening again, and engineers will be the first to lose their shirts when the markets turn against the tech sector. Most employees at public companies have too much invested in their employers.

While megacap stocks like Coca-Cola may offer exposure to the global economy, if the majority of a person’s investments are limited to one nation’s companies, their personal wealth will rise and fall with that nation. And that’s not a bet they should be making.

Simon Moore CFA, MBA, is Chief Investment Officer at the award winning retirement service FutureAdvisor. FutureAdvisor provides an online service to analyse and improve upon your retirement savings choices. It takes only a few minutes. See your free analysis at www.futureadvisor.com.

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