There’s a big wide investing world out there, covering every part of the globe, but most folks actually don’t wander too far from their own backyards. And that’s human nature: to varying degrees, people are naturally inclined to favor domestic assets – and shun the ones from further afield. Psychologists call it “home bias”, and it can have a huge impact on your portfolio. So let’s take a minute to get familiar with this tricky mental tendency to make sure it doesn’t keep you from achieving your goals.
First, what’s the root of this bias?
Experts say there are four major causes of home bias.
Risk aversion. Rightly or wrongly, investors often think it’s riskier to invest abroad, so they gravitate toward companies they know best – ones that are more familiar to them and land safely in their comfort zone. That often leads them to investments that are close to home.
Regulations, transaction costs, and currency risk. The more complicated an investment seems, the more off-putting for some investors. Investing abroad can involve added costs but some of the latest platforms have made it possible to keep these to a minimum, and that means you can invest with very low transaction charges (or none at all). There are also ways to smooth out the foreign exchange fluctuations that might eat into your profit – for example, by picking exchange-traded funds and other assets that are hedged.
Information asymmetry. Investors often believe they have better information about companies in their home markets and assume they can boost their investment returns by having a higher weighting in domestic stocks. That’s not always the case: these days, stock information from most economies is online and readily available.
Static allocations. Sometimes people do things simply because that’s the way they’ve always done it. And that’s the case with folks whose allocations have been the same for a long time. Unfortunately, that can leave investors over- or under-exposed to certain countries, assets, or sectors. It’s a situation that’s easily remedied, however, simply by ensuring that you (or your financial adviser) monitor and review your investments, at least once a year.
Does home bias hurt (or help) investing performance?
Well, that depends on where you’re based, and when.
A study in 2023 by the Federal Reserve Bank of Atlanta found that US stocks made up about 50% of global market capitalization, but that US investors were allocating about 90% of their stock portfolio to the US market. That’s a considerable overweighting. And, sure, having a home bias to the US stock market over the past few years would have resulted in stellar returns, both because the US stock market has outperformed other global markets and because the US dollar has been one of the strongest currencies. But, there’s no reason to believe that will continue forever.
UK-based investors have also long succumbed to home bias, but in recent years, that’s produced a very different outcome. The decline in the size of the UK market relative to the rest of the world, its stock market’s poor performance, and the fall in the value of the British pound would have led to pitiful investment returns for those folks who’ve been over-exposed to the UK.
The global weighting in UK stocks from 1998 to January 2024. Source: Fidelity.
And this surprised me: according to Fidelity, the average balanced model portfolio in the UK holds around 25% of its stock exposure in UK stocks. However, the UK accounts for just 3% of global economic output and only 4% of global stock markets. So that’s a big overweight – not to mention a hugely regrettable investment allocation decision.
The major stock indexes in the US and Japan have been the strongest in the past decade, while Europe and the UK have been the weakest, and that’s before factoring in currency movements. And it’s been especially true in the past four years.
The total return of the UK’s FTSE 100 (white), the US’s S&P 500 (blue), Japan’s Topix (purple), and the MSCI Europe (red) indexes, over the past ten years, given a starting point of 100. Source: Blomberg.
So how do you reduce the downside risk of home bias, while still finding opportunities?
Here’s where you’ll want to remember that age-old investing advice: don’t put all your eggs in one basket.
A multi-asset approach to investing in stocks, bonds, and commodities across different regions produces a more diversified portfolio and less volatile returns. A standard approach, at both global and local market levels, is to invest proportionally according to the country’s market capitalization. The Vanguard Total World Stock ETF (ticker: VT; expense ratio: 0.07%) does just that. It’s cheap, with a low expense ratio, and it’s aptly named – about 64% of its stocks come from the US, 15% from Europe, 11% from Pacific Rim countries, and 10% from emerging markets. It’s the easiest way to get balanced global stock exposure.
Or, you could build your own portfolio. The US has around a 64% weighting in the total global market cap and you could buy the SPDR S&P 500 ETF Trust (SPY; 0.09%) to get that exposure. But be aware that tech stocks, like Microsoft and Nvidia, have an increasingly big weighting in the S&P 500 Index, thanks to their strong profit growth and share prices.
If you’d like to reduce your tech exposure a bit, you could consider investing a small portion in the Invesco S&P 500 Equal Weight ETF (RSP; 0.2%) and another portion in the small-cap stocks that have struggled in the higher interest rate environment via the iShares S&P SmallCap 600 UCITS ETF (ISP6; 0.3%). Those shares have exposure to a wider part of the US economy and trade at lower valuations than the SPDR S&P 500 ETF. Then again, maybe you love the growth profile of tech and want to increase your tech exposure: it’s a personal choice after all.
Europe, including the UK, comes next with around 16% weighting in the global stock market cap, and Japan with a 6% weighting. Emerging markets – including China, India, and Taiwan – have around a 10% weighting based on market capitalization. You can choose ETFs or other funds to replicate those levels or adjust them to suit. Right now, Europe, Japan, and India are popular choices, thanks to their strong growth outlooks.
But as you build your asset mix, it’s worth keeping in mind that the outperformance of the US market has led to its valuations – including tech and excluding tech sectors – to become expensive, both compared to other countries’ and relative to their own history.
The 12-month forward price-to-earnings (P/E) multiple for MSCI regions for the past 20 years. Orange diamonds indicate the current valuation based on forward P/E ratios for markets, gray squares indicate median P/E ratios, and the thin gray lines indicate the range of valuations over the past 20 years. Source: Goldman Sachs
The UK market is the only country that’s currently trading cheaply versus its history – with the current valuation based on forward price-to-earnings (P/E) ratios (orange diamond) below the median P/E ratios (gray square). It’s also the cheapest of all global regions. So it’s no wonder private equity shops have been increasingly active in the UK market this year – picking up companies for cheap. And with that being the case, maybe having a home bias could be sensible for UK-based investors. With UK stocks having very little exposure to technology, they could be a good portfolio diversifier for a US-focused portfolio – making the iShares MSCI United Kingdom ETF (EWU; 0.11%) a potentially attractive bet.