What’s home bias?

The term home bias refers to the tendency for investors to invest the majority of their portfolio in domestic equities, ignoring the benefits of diversifying into foreign equities. Initial theories attributed this tendency to foreign equity investment challenges, including regulatory prohibitions and higher transaction costs. Some investors may have a home bias, preferring familiarity over risk.

Understanding Home Bias

Home bias is a common phenomenon in equity markets. Emotions rather than objectivity are frequently what motivate them. Home-biased investors prefer familiar investments. They’ll invest in domestic stocks rather than foreign ones. These investors feel more comfortable investing in their own country.

Many factors can make an investor prefer domestic investments, including:

• Greater availability of domestic investments
• Inexperience with foreign markets
• A lack of transparency
• Costs of transactions
• More significant barriers to entry in foreign markets
• Higher risks connected with foreign investment
• A preference for home markets above international investments

U.S. stocks represent around 60% of the worldwide market. According to Charles Schwab, Americans invest 85% of their portfolios in domestic equities. Research demonstrates that some generations are likelier to exhibit home bias than others. For instance, the largest group of respondents to Charles Schwab’s survey—baby boomers—have up to 45% of them in some way biased toward their homes. Millennials were the least likely, with only 24% of investors primarily concentrating on U.S. markets.

Home bias doesn’t simply apply to individual investors. Some professional U.S. mutual fund managers will likely demonstrate the same behavioral biases in their portfolio decisions as individual investors. The study showed that the average fund tends to be overweight in stocks from its managers’ home states. One crucial item to notice is that the researchers found the bias to be greater among less experienced managers.

Not just American investors have home bias. Investors worldwide tend to be predisposed toward investing in their home equities, like Finland, Japan, and Germany. And it’s also typical among investors who are more experienced and knowledgeable.3

Special Considerations

Systemic risk refers to risks that affect the whole market segment, not just one stock or industry. Some investors consider systemic risk country-specific, even though it is often non-diversifiable. Foreign shares reduce systematic risk in a portfolio because domestic market fluctuations less impact them.

Home prejudice, country bias, or familiarity bias

Home Diversity vs. Bias

Lack of alternatives and higher restrictions on accessing international markets have typically fueled home bias.

Mutual funds and ETFs offer a simple, low-cost way to diversify across international investments that may be challenging to access independently. Globally focused financial media and free information simplify buying and tracking overseas equities.

Diversification lowers risk by distributing investments across different asset kinds, locations, and sectors. The strategy aims to maximize returns by diversifying investments to mitigate the impact of market events on a portfolio.

Globalization

Foreign markets may not be as closely correlated with domestic performance. An economic downturn in the U.S. may not hurt another country as much. Investments in equity in that country protect against losses from changes in the U.S. economy.

However, globalization is integrating economies. A recession in one economy can affect others. Consider the effects of the U.S. subprime crisis on other economies. Why? The U.S. economy is the world’s largest and affects most nations. However, these considerations must be considered when investing in international shares to ensure diversification.

Tax advantages

Foreign investments may be tax-beneficial depending on the country’s tax legislation. Many countries offer foreign investors favorable tax rules, especially in wealthy nations. This practice is common in emerging markets to attract investment and promote growth.

U.S. investors may benefit from the foreign tax credit, but they still must pay taxes on income generated overseas. U.S. and foreign countries tax investments, but the foreign tax credit eliminates double taxation. The foreign tax credit cuts your tax burden by the lesser of the foreign tax or the U.S. tax liability, dollar-for-dollar.

Conclusion

• Home bias is an investor’s preference for native stocks over overseas assets.
• The home bias was due to transaction costs, inaccessibility, and unfamiliarity with international stocks.
• Home bias may be more prevalent in some generations.
• Home bias impacts individual and professional investors, including mutual fund managers.
• Information and ETFs make overseas equity investing easier.