Home sweet home. We all have a bit of home bias. The key is don’t let it impact your investing.
In investing terms, home bias is where investors fill their portfolios with stocks from their home country. Here’s why this might be a bad idea.
For most of us, the question of whether to take a passive DIY approach to investing using cheap index funds is a no brainer. In fact, it goes without saying that unless you can see into the future this is the approach you should take.
The theory is simple. The majority of investors will only earn a return equal to the market minus their fees. Consequently, the lower the fees, the higher the return. If you agree that this is the approach you should take, then the only question is which funds to invest in.
There are lots of different model portfolios out there for you to choose from. They usually contain bonds, some contain real estate, a few contain gold, and the odd one even contains other commodities. However, they all tend to have one thing in common and that’s a stock allocation.
Most experts will argue that if you want to grow your wealth you should have stocks in your portfolio. The amount and location of stocks can vary greatly but the fact that you have some is usually undebatable.
Most of the articles on this site advocate investing in index funds using exchange traded funds. However, with over 5000 exchange traded funds (ETFs) currently available choosing which stocks to add isn’t as straightforward as it used to be.
A lot of investors just invest in their home countries stocks. This is home bias. Perhaps they feel more confident investing in companies they know. Maybe they are attracted by low fees. FTSE100 index funds, which contain a basket of the UK’s top 100 companies have Total Expense Ratio’s as low at 0.04%, which is cheap by anybody’s standards.
Warren Buffet doesn’t see any problem with home bias for Americans. He thinks they should just stick to US stocks:
The S&P500 contains an index of 500 large US companies, but how about British investors? Well, you could just invest in the US anyway. A lot of those S&P 500 companies do business in the UK. Alternatively, you could invest in a UK fund like the FTSE 100 or the FTSE All Share Index which invests in even more UK companies.
It would certainly make life simple to follow Warren Buffet’s advice and just have one fund that you invest in, but most experts recommend adding bonds to a portfolio. Bonds add balance and reduce risk. In fact, on other occasions Buffet has suggested allocating 10% of a portfolio to bonds.
There are lots of model portfolio’s out there for investors to copy. Many of the most famous ones have some combination of stocks and bonds. Perhaps, the most famous one is called the Couch Potato.
The Couch Potato is evenly split between one stock fund and one bond fund. 50% bonds and 50% stocks. The Couch Potato is a great portfolio, but it is aimed at Americans, investing in the S&P500.
British investors could just replace the S&P500 with the FTSE All Share Index. Though this approach has a lot going for it, you don’t have to read too much about investing to begin to realize the importance of diversification. If you just invest in one country’s stock market there is a danger that you are putting all your eggs in one basket. Countries sometimes go through bad times. To avoid home bias, investors should diversify.
At the time of writing, the Shenzhen and Shanghai stock markets in China are down about 40% from what they were 10 years ago. Even worse is the Japanese stock market, down about 40% from what it was 30 years ago. You probably don’t have to convince Japanese or Chinese investors about the downside of home bias.
A lot of people in the DIY investing space seem to understand home bias. Many of them advocate a three-fund portfolio, where you invest in a fund of stocks from your home country, an international fund, and a bond fund.
For expats who aren’t planning on going home, the fund of stocks from your home country could be replaced with your retirement destination. For example, a UK expat who intends to return to Britain would have a UK fund, an international fund, and a bond fund. On the other hand, a UK expat who intends to retire in the US would have a US fund, an international fund, and a bond fund.
Lots of people take this approach, and it is logical. A fund from your target country gives you exposure to the market of that country. Many argue that this is sensible because in the end you will be paying for things there. At the same time, the international fund allows you to spread your bets.
The thing is, though this approach reduces home bias, it doesn’t necessarily solve the problem. That’s because this method still tends to overweight the home market.
In his book Investing Demystified, Lars Kroijer, recommends a single global fund. This is always the case, no matter where you are from or where you intend to retire. According, to him, even British residents, who return to Britain, don’t need a dedicated UK fund. Instead he suggests that a single global fund is all that is required.
Lars says most global funds automatically take care of how much of one country’s stocks to have. This is because global funds include different countries by market capitalization. This means the exposure of a particular country will be equivalent to that country’s share of the world market.
At the time of writing, the US currently makes up over 50% of the world market. Consequently, a global fund would have over 50% allocated to US stocks. Similarly, Japan makes up 8.5% of the world market so the fund would have 8.5% allocated to Japanese Stocks and so on.
Because the funds are geographically split in this way a global fund has already got exactly the right exposure to each country’s market. As a result, if you have more or less of one country in your portfolio compared to its fraction of the world markets, you are practically gambling. In fact, you are going against what the multi-trillion-dollar international financial market thinks. Maybe Warren Buffet could do that, but most people shouldn’t.
This is important because lots of people heavily weight their home markets. The chart below from Vanguard illustrates different countries home bias.
The UK share of the market is 7.2% but UK investors have 26.3% of their portfolio in UK stocks. This is still a bias towards all things British. These UK investors are effectively betting against all the hedge funds and investment banks out there. When you think about all the recourses, talent and, experience these institutions have at their disposal that can’t be a good idea.
On a more positive note, it seems that UK investors aren’t as bad as some other nationalities. In fact, according to the chart, they show the least home bias from the countries considered. Australian’s are the worst for home bias because though Australia makes up just 2.4% of the world market, Australians fill their portfolio’s with 66.5% Australian stocks.
If the Australian stock market keeps going up there won’t be a problem, but what if what happened in Japan was repeated in Australia. Maybe, the likelihood is remote, but the risk is there.
The bottom line is this, is home bias a risk worth taking, when, at the end of the day, investing in a global fund removes that risk?