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How harmful is home country bias?

Stephen Clapham assesses the dangers for investors of sticking too close to familar territory
How harmful is home country bias?

Another headline, “Pound sinks to new low”, made me think about home country bias. Probably a majority of private investors prefer to invest in their home market. Could such a bias exist in other fields? Imagine Mercedes F1 without Lewis Hamilton, the Cincinnati Reds without Joey Votto, and Manchester City without Kevin De Bruyne. Yet home country bias is highly prevalent among investors, as shown in studies including Home, 'sweet home: implications of the US home country bias' by Goldman Sachs Asset Management.

According to Goldmans’ Izabella Goldenburg, the reports's author, addressing US investors, “avoiding non-US equities may result in investors potentially missing attractive returns. Of the top 50 performing global stocks each year, on average, more than 75 per cent have been domiciled outside of the US over the last decade”.

I checked my own portfolio and, excluding two funds denominated in sterling but invested in global stocks (mainly US), my sterling holdings are less than 10 per cent of the total. I have increased exposure in the past 12 months as I thought the UK was cheap. There are a number of reasons why I believe it’s a sensible strategy to have a low exposure to my home market, but there are pros and cons.

 

 

Stick to what you know

Behavioural economists refer to this as familiarity bias. An important advantage for an investor is local knowledge and it should not be underestimated. The problem is it is often overestimated. Investors think they know the business but often they do not know the stock. Imagine that each time you visit, there is a big queue in M&S (MKS) or Target (US:TGT); that makes you more attracted to the stock. Intuitively, that makes sense as you can see the popularity with your own eyes and you like the new product range. But investors often overweight their chances of correctly identifying that investment opportunity.

By contrast, if you invest in an overseas stock with which you are less familiar, you are likely to place more weight on the investment facts and on the data, with less emotional influence on your assessment of the opportunity. Of course, I am not suggesting you are better off investing in companies you don’t know. But familiarity can make you feel more comfortable with your assessment while investing overseas may require a greater discipline.

The real advantage of investing at home is the ability to gain verifiably greater knowledge of the business and of the local economic conditions – experienced investors build up networks which can be critical in identifying early warning signals in a stock. That can really be helpful. This advantage should certainly be exploited in your portfolio, but that should not exclude investments overseas.

 

Will the US continue to do well?

If you live in the US, home country bias has paid off – the dollar has been pretty strong and the US market has significantly outperformed the rest of the world in the past several years. You also have the advantage of a wide selection of stocks and, of course, exposure to the biggest tech winners in the world. So that has had a good outcome, although not one that was necessarily predictable say 10 years ago. In the previous decade, exposure to Europe would have offered a currency benefit as the dollar depreciated against the euro.

If you lived anywhere outside the US, however, a totally domestic portfolio would have cost you dearly. Not owning some US stocks will have been a major drag on your performance. This is particularly true if you are a UK investor, as the UK market has been soft and the currency has collapsed since the Brexit vote – the pound buys 35 per cent fewer dollars than before the financial crisis.

Given the strength of the dollar and the valuation of the domestic market, particularly some tech stocks, it’s unlikely that US exposure will be as helpful in the next decade. Given the uncertainty facing equity investors as we navigate higher inflation, financial repression and demographic and growth headwinds, I believe stock selection will be harder. A broader universe may therefore be helpful.

 

Currency issues

The single most important reason for investing at home is to avoid currency risk. If this is your US or UK pension pot, you will need dollars or pounds to spend when you retire. If your domestic currency appreciates, and you own a lot of global stocks, your local currency returns will suffer, and this could happen when you are ready to draw a pension or cash in some of your gains. Therefore, I would suggest that you increase your domestic exposure as you approach the requirement for the money (for example, on retirement). But it’s hard to avoid currency risk entirely – even a domestic investor will often be investing in global companies which are themselves subject to the vagaries of currency moves.

As a UK-based investor, I have been happy to own overseas assets while the pound has been weakening. As it doesn’t appear particularly cheap today, I am happy to continue with my domestic underweight. It’s possible that the pound will stage a resurgence, and my portfolio could suffer. But that’s a risk I am comfortable with, although it might not be for everyone.

One major drawback in multi-country exposure is the need to keep tabs on major currency movements. I hadn’t expected the recent weakness in the Yen – stupidly, as it was fairly obvious that investors would prefer to own dollars with rising rates than Yen with zero rates. So my hopes for the Japanese stock market have been undermined by the currency weakness.

 

Global perspective

The single most important reason in favour of a diversified as opposed to a domestic approach is that the best stocks are not necessarily going to be found in your local market. I was a global investor for a number of years, both as an analyst and as a portfolio manager, and I have always preferred to look at a global canvas when trying to find stock ideas. Good ideas are hard to find and artificially restricting where you look seems an unnecessary handicap.

Some will prefer to stick to developed markets and avoid emerging markets, which are perceived as riskier. They may be, but there are often greater mispricing opportunities in these smaller markets where there is less competition to find cheap stocks. And having a global canvas means you take in information from a wider range of sources. This can sometimes benefit domestic investments, too.

 

Sector diversification

If you stick to your domestic market, you may be unable to gain sufficient diversification across sectors, especially if you are using an index fund – for example, If you are UK-based, you would have been overweight miners and energy and had a near-zero weighting in tech. And the tech you did have probably went down if you were invested in a Deliveroo (ROO) or even worse, THG (THG).

Smug US investors should think carefully about this risk as the pendulum is swinging the other way and those UK weightings to commodities and energy could continue recent outperformance against much of the highly valued US tech stocks over the next few years.

 

Country correlation

Markets have become more correlated over time, so using index exchange traded funds (ETFs) may not produce as much diversification as hoped, and certainly less than 10 years ago. It’s unclear whether this correlation will be maintained, especially in a less globalised economy. Although the diversification benefits may be lower than they were, there is still a reduction in risk.

 

Don’t put all your eggs in one basket

Most people have limited flexibility in where they work, while moving countries is difficult, expensive and often considered undesirable. Yet many people not only have all their earnings coming from their domestic market but 100 per cent of their wealth also. This can be a risk in a major downturn, when you might need access to your financial capital because of a problem with your employer. Stock options and similar schemes should be included in any weighting analysis. 

Given that for many, your home is your single largest asset, surely that is an even more compelling case for diversifying the remainder of your wealth. It’s hard to hold bonds today, but to the extent that bonds are affording an income stream, then that’s likely to be desired in the domestic currency. If you get all your income in one currency, and the property and fixed income portions of your capital are in the same currency, surely that is a good reason to diversify your equity exposure?

 

Minor factors to consider

Trading and similar costs

The frictional cost of overseas exposure is significant and I am fed up with hidden charges. I find it strange that a platform such as Hargreaves Lansdown in the UK, which is charging onerous platform fees, then loads additional foreign exchange charges, and not in a transparent way. US domestic charges are particularly low and hence the cost of overseas diversification is higher; this might help explain the 70 pe cent-plus domestic weighting in US portfolios. A broker that decided to charge sensibly and transparently for a global account would surely clean up. Another inhibiting factor can be double taxation of dividends, which operates in several jurisdictions.

Political risk

One valid reason for preferring domestic exposure is that political, regulatory or other economic risks are hard enough to understand in your home market, let alone in Japan or Germany. This is one area where local knowledge can be really important. I get around this by rarely investing in overseas stocks that have significant regulatory exposure – utilities, for example. Sometimes, you will get caught out by an unexpected development, one that it’s possible that you might have anticipated in your home market. That is a cost of diversification.

The academic perspective

The first study I found showing that investors hold most of their wealth in domestic markets in spite of the benefits of international diversification was over 30 years ago ('Investor diversification and international equity markets, Kenneth R French and James M Poterba'). Another, published 25 years ago, showed a similar domestic bias and a higher turnover rate in foreign holdings, suggesting that transaction costs were not a major factor for those who had diversified ('Home bias and high turnover', Linda Tesar and Ingrid M Werner). A third showed that US investors preferred companies with local headquarters – a home state bias, beyond the country bias ('Home bias at home: local equity preference in domestic portfolios', Joshua D Coval and Tobias J Moskowitz). This preference for familiarity is understandable, but in my view risky.

Capital controls

These haven’t been in general operation in the west for a long time, but they have been introduced when countries have been under pressure – Iceland and Argentina have seen them, as has Russia of late. One potential consequence of high levels of government debt and potential financial repression could be the need for certain countries to introduce capital controls to stop investors avoiding the compulsory purchase of domestic government bonds. Sounds unlikely, I know, but certainly not impossible. Having money parked overseas is an insurance policy against the introduction of capital controls.

 

Conclusions

There is no reason to have all your money in the domestic market. If you are in the US, it has served you well, but perhaps not for much longer. If you are in the UK, it has been a massive cost and, although it may benefit performance in the next few years, it’s risky. A globally diversified portfolio is lower risk and ultimately is likely to be a more rewarding strategy.