Home country bias

What Is Home Country Bias?

Home country bias, a significant concept within behavioral finance, refers to the persistent tendency of investors to allocate a disproportionately large percentage of their portfolio to domestic assets, specifically equities, compared to what global capital markets would suggest as an optimal allocation. This inclination often occurs despite the widely recognized benefits of global diversification. Even with increasing globalization and easier access to foreign markets, investors frequently exhibit this preference for familiar investments. The presence of home country bias can significantly impact an investor's risk-adjusted return.

History and Origin

The phenomenon of home country bias gained significant attention in academic finance in the early 1990s. Early empirical research, notably by Kenneth French and James Poterba in their 1991 study, highlighted the surprisingly high proportion of domestic equities held by investors in various developed nations, contrasting sharply with the predictions of international asset allocation models that advocate for a globally diversified portfolio.²⁸ These findings, which quantified the extent of home country bias in countries like the U.S., Japan, and the UK, spurred extensive research into its underlying causes.²⁷ Initially perceived as a "puzzle" in international macroeconomics, the continued prevalence of home country bias has led researchers to explore a range of explanations beyond purely rational economic behavior.

Key Takeaways

• Home country bias describes investors' tendency to overweight domestic assets in their portfolios.
• It is a widely observed phenomenon in financial markets globally, impacting both individual and institutional investors.²⁶
• Reasons for home country bias include familiarity, perceived informational advantages, currency risk, and higher transaction costs associated with foreign investing.²⁴, ²⁵
• Despite its prevalence, home country bias can lead to suboptimal portfolio diversification, potentially increasing systematic risk and limiting exposure to growth opportunities in international markets.²³
• Modern investment vehicles like Exchange-Traded Funds (ETFs) and mutual funds have made international investing more accessible and cost-effective, offering avenues to mitigate home country bias.

Interpreting the Home Country Bias

Home country bias is typically interpreted as a deviation from what a perfectly diversified global portfolio would imply. In a world with frictionless markets and perfect information asymmetry, theoretical models like the International Capital Asset Pricing Model (ICAPM) suggest investors should hold a portfolio reflecting the global market capitalization of assets.²² For instance, if a country's equity market represents 5% of the total global market capitalization, then a rational, unbiased investor should ideally allocate approximately 5% of their equity portfolio to that country's stocks. When an investor holds significantly more than this proportion in their domestic market, they are exhibiting home country bias.

The degree of home country bias can indicate the extent to which an investor's portfolio is undiversified internationally, exposing them to concentrated risks specific to their domestic economy, political landscape, and market cycles. A high degree of this bias suggests that the investor is potentially foregoing the benefits of international portfolio management, such as reduced volatility and access to diverse growth opportunities.²¹

Hypothetical Example

Consider an investor, Sarah, who lives in Country A. The global equity market capitalization shows that Country A represents 10% of the total world stock market. An optimal, globally diversified portfolio would suggest that Sarah allocates about 10% of her equity investments to Country A's stocks, with the remaining 90% spread across other international markets, including developed markets and emerging markets.

However, Sarah feels more comfortable investing in companies she knows from her home country. After reviewing her investment portfolio, she finds that 70% of her equity holdings are in Country A's stocks, while only 30% are in foreign equities. This significant overweighting of domestic assets (70% vs. the suggested 10%) illustrates a strong home country bias in Sarah's investment strategy. Her portfolio's performance would be heavily dependent on Country A's economic conditions and market movements, potentially missing out on gains from faster-growing economies elsewhere or suffering more severe losses if Country A experiences an economic downturn.

Practical Applications

Home country bias manifests across various facets of investing and market analysis. It is frequently observed in the asset allocation decisions of individual investors, institutional funds, and even professional money managers.²⁰ For individual investors, the bias often stems from a combination of psychological factors, such as familiarity and overconfidence in domestic prospects, and practical considerations, including perceived higher costs or less accessible information for foreign investments.¹⁸, ¹⁹

Regulators and financial advisors often emphasize the importance of international diversification to mitigate this bias. The U.S. Securities and Exchange Commission (SEC), for example, provides guidance for investors considering international investments, highlighting the benefits of spreading risk and accessing growth opportunities outside the domestic market, while also outlining associated risks.¹⁷ Furthermore, academic research frequently analyzes capital flows and investment patterns to quantify home country bias and understand its implications for global financial stability and market efficiency.¹⁶ It has been noted that the increasing reach of multinational corporations might implicitly provide some level of international exposure even within domestic holdings, though this does not entirely negate the bias.¹⁵

Limitations and Criticisms

While home country bias is a well-documented phenomenon, its severity and implications are subject to ongoing debate and criticism. Some arguments suggest that the perceived extent of home country bias might be overstated, particularly when accounting for factors like multinational corporations. Companies with a primary listing in an investor's home country may still derive a substantial portion of their revenue from international operations, providing a degree of indirect global exposure.¹⁴ Additionally, evolving financial landscapes and increased transparency in global markets have made international investing more accessible, potentially leading to a decline in home country bias, particularly in developed markets.¹³

Critics also point out that certain rational factors can contribute to a domestic overweighting, such as hedging against domestic consumption needs, tax implications, or regulatory complexities in foreign jurisdictions.¹² However, these factors rarely fully justify the observed levels of home country bias, and many studies continue to highlight its persistent nature and the potential for suboptimal portfolio outcomes due to undiversified exposure.¹¹ For instance, a European Central Bank working paper suggests that the presence of financial centers might distort measurements of home bias, potentially making it appear more severe than it truly is for some investor groups.¹⁰

Home Country Bias vs. Local Bias

While both terms describe an investor's preference for familiar investments, home country bias and local bias refer to different scales of geographic concentration. Home country bias is a macroscopic phenomenon, reflecting an investor's tendency to disproportionately favor investments within their own nation's borders, relative to the global market portfolio. It is concerned with the allocation between domestic versus foreign assets.

In contrast, local bias is a more granular, intra-national phenomenon. It describes an investor's preference for assets from companies located in close geographic proximity to them, even within their own country. For example, a Californian investor exhibiting local bias might heavily invest in California-based companies, even if their portfolio already has a strong overall U.S. domestic weighting. The underlying drivers, such as familiarity and ease of information access, are similar for both biases, but local bias emphasizes proximity within a country, whereas home country bias focuses on the national border as the dividing line for investment preferences.⁹

FAQs

Why do investors exhibit home country bias?

Investors exhibit home country bias for several reasons, including a preference for the familiar, a perceived informational advantage about domestic companies, higher transaction costs and legal complexities associated with foreign markets, and the desire to avoid foreign currency risk.⁷, ⁸

Does home country bias apply to all types of investors?

Yes, home country bias is observed across various investor types, including individual retail investors, sophisticated institutional investors, and professional portfolio managers.⁶ Its magnitude can vary, but the general tendency to favor domestic assets remains prevalent.

How can an investor reduce home country bias in their portfolio?

Investors can reduce home country bias by intentionally diversifying their portfolios globally. This can be achieved by investing in international ETFs, global mutual funds, or by directly investing in foreign stocks or bonds. Consulting a financial advisor can also help in constructing a balanced international asset allocation.⁴, ⁵

What are the main disadvantages of home country bias?

The primary disadvantages of home country bias include reduced portfolio diversification, which can lead to higher risk and volatility, missed opportunities for growth in faster-growing international economies, and an overexposure to the economic and political risks specific to the investor's home country.², ³

Is home country bias always irrational?

While often considered a behavioral bias that deviates from rational portfolio theory, some elements of home country bias can be attributed to rational factors. These include reduced information costs, lower transaction expenses, and hedging against domestic liabilities or consumption patterns. However, studies generally conclude that these rational factors do not fully explain the observed degree of home country bias, suggesting a strong behavioral component.¹