The term home bias refers to the tendency for investors to invest the majority of their portfolio in domestic equities, often neglecting the diversification benefits available by including foreign equities. This bias can stem from various issues such as legal restrictions, additional transaction costs, or simply a preference for familiar investments over the unknown.
Key Takeaways
- Home bias epitomizes an investor’s preference to concentrate on domestic equities rather than diversify across international investments.
- Challenges like transaction costs, inaccessibility, and unfamiliarity with foreign equities contribute greatly to home bias.
- Different generations display varying levels of home bias, with older investors often more inclined to invest domestically.
- Both individual and professional investors like mutual fund managers can exhibit home bias, sometimes due to a lack of experience.
- Modern investment vehicles like ETFs facilitate easier investment in foreign markets, encouraging diversification.
The Emotional Anchors of Home Bias
Home bias typically manifests within equity markets and is predominantly emotion-driven. Investors exert a stronger attraction toward domestic companies because they feel more familiar and comfortable with these investments, despite losing out on potential gains from foreign markets.
Factors Influencing Home Bias
- Greater availability of domestic investments
- Unfamiliarity with foreign markets
- Lack of transparency
- Higher transaction costs
- Increased barriers to entry in foreign markets
- Heightened risks with international investing
- Personal preference for domestic markets
For instance, U.S. equities make up about 60% of the global market, but Americans often invest around 85% of their portfolios in domestic equities. This home bias trend spans generations, with baby boomers showing a higher propensity for this bias compared to millennials.
Professional Bias
Not just individuals but even professional U.S. mutual fund managers often reflect similar biases. Interestingly, managers with lesser experience tend to demonstrate a stronger inclination towards domestic stocks.
Global Application
Home bias is not solely an American attribute. Investors worldwide, in places like Finland, Japan, and Germany, exhibit a strong preference for their respective domestic equities. Among both novice and seasoned investors, this bias prevails.
Special Considerations
Systematic risk pertains to risks that impact an entire market segment rather than a specific stock or sector. While often deemed non-diversifiable, investments in foreign equities could, for some, reduce systematic risk by its diversification aspect. Home bias is also referred to as country bias or familiarity bias.
Overpopulation of Domestic Investments vs. Diversification
Historically, the scarcity of options and formidable barriers in entering foreign markets have propelled home bias. However, investor-friendly tools like mutual funds and ETFs now afford relatively easy and cost-effective routes for diversification. Global financial media and free information flows further aid the selection and management of foreign stocks.
Globalization and its Dual Nature
Since economies today are profoundly interconnected, an economic downturn in the U.S. can ripple through other markets. A classic example is the global impact of the U.S. subprime meltdown. While true diversification becomes challenging amidst global economic integration, attention to multi-national exposure remains imperative.
Tax Benefits of Global Investing
Certain fiscal advantages exist for foreign investments due to beneficial tax laws in host countries. U.S. investors may also offset double taxation using the foreign tax credit, reducing overall tax liability based on the higher tax paid either domestically or abroad.
Engage with the world, diversify your portfolio, and reduce risk—don’t let home bias hold you back from global financial opportunities.
Related Terms: familiarity bias, country bias, equity diversification, systematic risk, foreign investments.
References
- Charles Schwab. “Fundamentals of behavioral finance: Home bias”.
- SSRN. “No Place Like Home: Familiarity in Mutual Fund Manager Portfolio Choice”. Download required. Page 31.
- Springer Link. “The home bias and the local bias: A survey”.
