It’s not just insular Americans who do it. Individual investors and investment managers around the world invest in domestic equities out of proportion to the percentage of the total international equity market represented by the equities of their country. It’s called the Equity Home Bias Puzzle, and while it varies dramatically from country to country, it’s true in every country.
As of the end of 2010, for example, U.S. equities represented 43% of global capitalization, yet U.S. investors allocated 72% of their equity holdings to U.S. stocks.
Home Bias has significantly decreased over the last few decades, but it remains the norm. No one has offered a definitive explanation for it, but economists have a number of theories that remain to be proven, including the potential tax disadvantages of foreign markets, uncertainty of information about foreign markets and overconfidence about picking stocks in domestic markets. Even academic theory comes into play: modern portfolio theory, for example, suggests that you should hold markets in proportion to their weight in the world market. Following that line of theory, if the U.S. comprised 43% of the world market, your portfolio would hold 43% U.S. stocks.
Economists variously attribute Home Bias’ steady decline to financial industry trends, including increased access to international investment vehicles, increased awareness of the value of international diversification, and lower costs. The decline may also be a result of globalization, increasing free trade, emerging markets and the emergence and dominance of the internet.
This is all fascinating for academics, but so what?
Equity Home Bias has two major consequences for investors. It decreases the opportunity to capture outperformance of specific foreign markets and of global markets in general. And it increases portfolio risk and volatility by reducing diversification and overweighting domestic market changes. In other words, having more U.S. stocks and fewer foreign stocks than you should have in your portfolio may, in the long run, reduce the potential of your returns. That assumes, of course, perfect information in every buying, selling and allocating decision.
Before you worry too much about this arcane corner of the investment world, talk with your advisor. He or she will take you through your portfolio’s equity allocation, and the reasons for it. Not everyone’s situation is the same, and your portfolio will need to be allocated and managed according to your specific needs. Indeed, international and emerging market investing involves special risks, such as currency fluctuation and political instability, and it may not be suitable for everyone.
Through our effectively diversified portfolios and a staff that monitors over 70 world markets looking for opportunities, we seek to deliver returns across a variety of markets and market conditions to capture returns wherever they are likely to occur.
