Local bias

What Is Local Bias?

Local bias, in the context of investing, is a specific type of cognitive bias within behavioral finance where investors disproportionately favor assets from companies whose headquarters are geographically close to their own residence. This phenomenon suggests that individuals tend to invest in what is familiar and physically proximate, rather than strictly adhering to principles of portfolio diversification based on optimal risk-adjusted returns. Local bias is distinct from, though often discussed alongside, home bias, which refers to the tendency to overweight domestic equities relative to a global benchmark. While home bias is national, local bias operates on a more granular, intra-national level, focusing on geographic proximity within a country.

History and Origin

The study of biases influencing investment decisions has roots in the broader field of behavioral finance. While the concept of home bias was formally identified and explored by Kenneth French and James Poterba in 1991, highlighting investors' strong preference for domestic equities, the idea that geographical proximity within a country also impacts investment choices emerged later.,²⁰

Academic research began to distinguish local bias as a separate, intra-national phenomenon. Notably, a 1999 study by Coval and Moskowitz presented evidence that U.S. investment managers exhibited a strong preference for locally headquartered firms, particularly smaller, highly leveraged companies.¹⁹, This research helped solidify local bias as a recognized pattern of irrational behavior in portfolio management, suggesting that factors beyond pure financial metrics often guide investor actions. Further literature reviews confirm that most research on local bias has focused on individual investors, exploring potential causes like informational advantages or mere familiarity.¹⁸

Key Takeaways

• Local bias is an investment preference for geographically proximate companies, influencing asset allocation outside of purely rational financial metrics.
• It is a distinct behavioral finance concept, differing from the broader home bias, which refers to a preference for domestic over foreign assets.
• Studies suggest that local bias can lead to concentrated equity portfolios and may not necessarily result in superior returns.
• The bias is often attributed to perceived informational advantages or simple familiarity with nearby firms.
• Acknowledging local bias can help investors evaluate their asset allocation and pursue more optimal global diversification strategies.

Interpreting the Local Bias

Interpreting local bias involves understanding that it represents a deviation from a theoretically optimal, globally diversified portfolio. When an investor exhibits local bias, their portfolio composition is influenced by factors unrelated to a company's fundamental financial health or its contribution to overall portfolio risk reduction. Instead, proximity, perceived familiarity, or ease of obtaining information about a local company can drive investment choices.¹⁷

While some research has explored whether local investors gain an information asymmetry that leads to superior returns, the evidence is mixed and often indicates that individuals do not consistently outperform by investing locally.¹⁶ Therefore, a strong local bias can signal an under-diversified portfolio, potentially exposing the investor to unnecessary idiosyncratic risk tied to a specific region or local economy. Recognizing this bias encourages investors to critically evaluate their geographic exposure and consider a broader universe of investment opportunities.

Hypothetical Example

Consider Jane, an individual investor living in a mid-sized city in the Midwest. While setting up her investment decisions, Jane notices that a significant portion of her individual stock holdings are in companies headquartered within a 100-mile radius of her home. These include a regional bank, a local manufacturing firm, and a tech startup that gained popularity in her city.

Jane chose these stocks primarily because she drives past their offices, sees their products advertised locally, or knows people who work there. She feels a sense of familiarity and believes she has better insight into their operations than she would for a company based across the country or overseas. This preference, based on geographical closeness, is a clear example of local bias influencing her investment portfolio. Although these companies might be viable investments, her primary rationale for selecting them is their proximity, rather than a comprehensive analysis of their financial performance relative to the global market.

Practical Applications

Local bias manifests in various areas of investing, influencing how individuals and even professional managers construct their portfolios.

• Individual Investors: Many individual investors exhibit local bias by investing heavily in companies they know from their immediate environment. This often stems from a feeling of greater comfort or a perceived informational advantage about local businesses, which may not always translate into better risk-adjusted returns.¹⁵ For instance, a Vanguard study found that individual investors consistently exhibit local bias across geographic regions, associating it with more concentrated individual stock positions.¹⁴
• Mutual Funds and Professional Managers: While less pronounced than among individual investors, professional investment managers, including those managing mutual funds, have also been shown to exhibit some degree of local bias. This might be due to closer relationships with local management or easier access to local market information.¹³
• Venture Capital: The phenomenon is particularly strong in venture capital investments, where proximity to startups allows for more direct oversight and engagement.

Understanding local bias can help investors consciously broaden their investment horizons beyond their immediate surroundings. Investment vehicles like exchange-traded funds (ETFs) and globally diversified mutual funds offer practical ways to mitigate local bias by providing exposure to a wide range of companies and geographies, helping to achieve better portfolio diversification. As noted by the National Bureau of Economic Research (NBER), the benefits of international diversification have been recognized for decades, yet many investors continue to hold significant domestic assets.¹²

Limitations and Criticisms

While local bias is a documented phenomenon, its implications and underlying causes are subject to ongoing discussion and criticism within behavioral finance. One major limitation is that local bias, by its nature, often leads to undiversified portfolios. Investors who concentrate their holdings in local companies may forgo the benefits of broad market efficiency and expose themselves to concentrated regional or industry-specific risks. This lack of diversification can result in suboptimal risk management and potentially lower returns over the long term.

A key debate revolves around the "informational advantage" hypothesis versus the "familiarity" hypothesis. Some early research suggested that local investors might possess superior, private information about nearby firms, allowing them to achieve better performance.¹¹ However, other studies indicate that local bias often stems more from simple familiarity and comfort than from actual informational edge, and that local investments do not consistently generate superior returns.¹⁰ For example, some findings suggest that local stock purchases by individual investors may even underperform local sales.⁹ The complexity of behavioral biases highlights that human decision-making is often influenced by factors that diverge from purely rational economic models.⁸,⁷

Furthermore, measuring local bias can be challenging because "local" is not a clearly defined geographical area, unlike national borders for home bias.⁶ This makes comparisons across studies and regions difficult.

Local Bias vs. Home Bias

Local bias and home bias are related but distinct behavioral finance concepts that describe tendencies in investor behavior. Both represent deviations from optimal global portfolio diversification.

While home bias focuses on the national border as the dividing line for investment preferences, local bias delves deeper into geographical proximity within that national border. An investor exhibiting home bias might still distribute their domestic holdings broadly across their home country, whereas an investor with local bias would concentrate investments within their immediate vicinity. Both biases can hinder an investor's ability to achieve full diversification and may lead to suboptimal long-term portfolio performance.

FAQs

Why do investors exhibit local bias?

Investors exhibit local bias primarily due to familiarity and a perceived informational advantage. They often feel more comfortable investing in companies they see or hear about regularly in their local area, assuming they have better insights into these businesses.⁵ However, this perceived advantage does not always translate into superior returns.

Is local bias a rational investment strategy?

Generally, no. Local bias is considered a behavioral bias because it often leads to undiversified portfolios. While a local company might be a good investment, choosing it primarily based on proximity rather than comprehensive analysis can expose an investor to unnecessary concentration risk, hindering optimal portfolio diversification.

How does local bias differ from home bias?

Local bias refers to investing in companies geographically close to an investor within their own country.⁴³ Home bias, a broader phenomenon, is the tendency to overweight investments in one's own country compared to the global market, irrespective of specific proximity within that country.²

Can professional investors suffer from local bias?

Yes, research suggests that even professional investors and mutual funds can exhibit some degree of local bias, though it is generally less pronounced than among individual investors.¹ This can be influenced by established networks or ease of information gathering within a certain geographical area.

How can investors mitigate local bias in their portfolios?

Investors can mitigate local bias by consciously seeking global diversification and focusing on objective financial analysis rather than geographic proximity. Utilizing broadly diversified investment vehicles like global index funds or ETFs can help ensure a portfolio is not overly concentrated in local or domestic assets, improving overall risk-adjusted returns.