Localism

What Is Localism?

Localism, in the context of finance and investing, refers to the tendency of investors to disproportionately allocate capital to assets and businesses within their immediate geographic vicinity, whether it be a specific city, region, or even neighborhood. This phenomenon falls under the broader umbrella of behavioral finance, as it often stems from cognitive biases and psychological factors rather than purely rational economic calculations. Investors exhibiting localism prioritize familiarity, perceived local knowledge, and a desire to support their community over optimal portfolio diversification and potential global investment opportunities.

This inclination towards local investments can manifest in various ways, from investing in stocks of companies headquartered nearby to backing small businesses in one's town through private placements or crowdfunding. While seemingly benign, localism can lead to concentrated portfolios with suboptimal risk management characteristics, as it often overlooks the benefits of broader market exposure.

History and Origin

The concept of investing close to home is not new and predates modern financial markets. Historically, investments were inherently local due to limited information, communication, and transportation capabilities. People invested in what they knew and could physically observe. With the advent of more sophisticated capital markets and global connectivity, the ability to diversify geographically increased dramatically.

Despite these advancements, the tendency towards localism persisted. Academic studies in finance began to formally examine this phenomenon, often linking it to what is known as "home bias" at an international level. Researchers Kenneth French and James Poterba, among others, first studied the broader concept of home bias in the early 1990s, noting that investors worldwide held a disproportionately high percentage of domestic equities compared to their market capitalization weight in the global economy. Subsequent work, such as that by Coval and Moskowitz in 1999, specifically highlighted that this bias also applies within a country, with fund managers and individual investors favoring firms headquartered closer to them, a phenomenon they termed "local bias." A comprehensive academic study discusses how both home bias and local bias describe investment behaviors where investors overweight assets from their home country or within a certain proximity, leading to a lack of diversification.¹²

Key Takeaways

• Localism is an investment bias where individuals favor assets and businesses geographically close to them.
• It is a concept rooted in behavioral finance, driven by factors like familiarity and community support.
• The bias can lead to concentrated portfolios that may lack optimal diversification.
• While supporting local economies, unmitigated localism can increase financial risk and potentially limit returns.
• Modern investment vehicles make global diversification more accessible, challenging the traditional rationale for localism.

Formula and Calculation

Localism, as a behavioral bias, does not have a precise mathematical formula for its calculation in the same way a financial ratio would. Instead, its presence is typically identified through empirical observation by comparing an investor's portfolio allocation to the geographic distribution of available investment opportunities.

Researchers quantify localism by measuring the deviation of an investor's or a portfolio's geographic concentration from a neutral, market-weighted benchmark. For example, if a region accounts for 5% of the total available market capitalization, but an investor from that region allocates 25% of their portfolio management to that region, the localism bias is evident.

One common approach to illustrate the degree of local bias, particularly in academic research, is to compare the proportion of an investor's portfolio invested in local stocks to the proportion that local stocks represent in the overall market portfolio. If ( S_{i,L} ) is the share of investor ( i )'s portfolio invested in local assets, and ( M_L ) is the share of local assets in the total market, then a measure of localism (LB) for investor ( i ) could be conceptualized as:

A positive ( LB_i ) indicates localism. This simplified representation highlights the core idea: an overweighting of local assets relative to their market presence. More complex models might factor in distance decay functions or control for specific investor characteristics.

Interpreting Localism

Interpreting localism in an investment context means understanding the motivations behind such investment choices and their potential implications. While localism can foster community loyalty and a sense of direct impact, it often stems from a lack of complete information asymmetry regarding distant opportunities, or simply a comfort with the familiar. Investors might believe they possess a "local information advantage" about companies in their area, even when publicly available information negates this.

A high degree of localism indicates a portfolio concentrated geographically, which can increase vulnerability to regional economic downturns or industry-specific shocks. Conversely, a portfolio with low localism, exhibiting broader geographic exposure, would generally align more closely with principles of sound asset allocation and risk reduction through diversification. The interpretation hinges on whether the local investment provides a genuinely superior return on investment that justifies the concentrated risk, or if it is purely a behavioral phenomenon leading to suboptimal outcomes.

Hypothetical Example

Consider an investor, Alice, who lives in a city heavily reliant on the tourism industry. Her personal investment portfolio, valued at $100,000, consists of the following:

• $40,000 in a local hotel chain stock
• $30,000 in a local restaurant group's bonds
• $20,000 in a diversified national stock index fund
• $10,000 in a national bond fund

In this scenario, $70,000 (70%) of Alice's portfolio is invested directly in her local economy, specifically in industries tied to tourism. While she might feel a sense of pride supporting her community and believes she has a good understanding of these local businesses due to her daily interactions, her portfolio exhibits significant localism.

If a global economic downturn severely impacts travel and tourism, Alice's local investments would likely suffer disproportionately compared to a more geographically diversified portfolio. Her belief in "knowing the local market" could lead to concentrated losses if unforeseen events, such as a natural disaster or widespread market volatility, specifically affect her region or its dominant industry. A more diversified approach, potentially including investments in emerging markets or other industries not tied to tourism, could help mitigate such concentrated risks.

Practical Applications

Localism is evident in various facets of the financial world:

• Individual Investing: Many retail investors, perhaps out of familiarity or a desire to support their community, tend to invest in companies they recognize from their daily lives or that are headquartered nearby.
• Regional Banks and Credit Unions: These institutions traditionally have a strong focus on lending to local businesses and individuals, thereby directing capital within specific geographic boundaries.
• Private Equity and Venture Capital: While some firms operate globally, many focus on regional ecosystems, investing in startups and growth companies within a defined geographic area, such as Silicon Valley for technology or specific hubs for biotechnology.
• Community Development Financial Institutions (CDFIs): These organizations are specifically designed to provide financial services and investments to underserved communities, inherently embracing a local focus to stimulate economic growth and job creation in those areas.
• Equity Crowdfunding: Platforms that facilitate investments in local businesses often see a strong local investor base, where individuals are drawn to supporting ventures in their own towns or cities. However, some academic research suggests that local investments in equity crowdfunding may more often pick startups that run into insolvency, indicating it can be a behavioral anomaly rather than a rational preference.¹¹

The Federal Reserve Bank of San Francisco has also explored the challenges of local business investment, noting the paucity of "market-clearing mechanisms" like local stock exchanges that would allow local investors to easily find, buy, and sell local securities, highlighting the systemic impediments to purely localized capital flow.¹⁰

Limitations and Criticisms

Despite some perceived benefits, localism in investing faces significant limitations and criticisms:

• Lack of Diversification: The most prominent critique is that localism inherently limits diversification, concentrating capital in a narrow geographic or economic band. This exposes the investor to specific local risks, such as regional economic downturns, natural disasters, or the decline of local industries. A geographically concentrated portfolio is more vulnerable to being wiped out by a single event.⁹
• Suboptimal Returns: Limiting oneself to local investments can mean missing out on superior investment opportunities elsewhere. Many local businesses, by their nature, are small and may not benefit from the economies of scale that larger, more globally exposed companies do, potentially leading to lower overall returns for the investor.⁸
• Perceived vs. Actual Information Advantage: While investors may feel they have superior knowledge about local companies, this perceived advantage often does not translate into better investment performance. Academic studies suggest that this "familiarity bias" does not necessarily help individual investors obtain higher returns.⁶, ⁷
• Liquidity Issues: Investments in small, local businesses, especially through direct stakes or private placements, are often highly illiquid. They are not traded on public exchanges, making it difficult to sell them quickly or at a fair market price when cash is needed.⁵
• Regulatory Restrictions: Outdated federal securities laws can inadvertently make it prohibitively expensive for local businesses to raise capital from small, local investors, thereby forcing Main Street to depend on Wall Street, as noted by the Federal Reserve Bank of San Francisco.⁴

As the White Pine Advisory highlights, while supporting local endeavors has merit, a portfolio overly concentrated in local investments can significantly increase financial risk and narrow investment horizons.³

Localism vs. Home Bias

Localism and Home Bias are related but distinct concepts within behavioral finance, both describing a preference for familiar investments. The key difference lies in their scope:

While home bias focuses on the national border as the primary demarcation, localism emphasizes distance within that border. Both biases, however, can lead to a lack of diversification and potentially suboptimal risk-adjusted returns by limiting an investor's universe of choices.

FAQs

1. Is localism always a bad investment strategy?

Not inherently. While excessive localism can lead to concentration risk and potentially lower returns, a measured approach to local investing can complement a broadly diversified portfolio. It can offer intangible benefits like supporting community economic growth or a perceived understanding of local market dynamics. However, it should not be the sole or primary basis for asset allocation.

2. How can investors overcome localism?

Overcoming localism involves consciously seeking out diverse investment opportunities beyond one's immediate surroundings. This can be achieved through investing in globally diversified index funds or exchange-traded funds (ETFs) that provide exposure to various countries, regions, and industries. Educating oneself on the principles of diversification and global market structures is also crucial.

3. Does localism only affect individual investors?

No, localism can affect both individual and institutional investors, including mutual fund managers. While individual investors might be driven by familiarity and community ties, professional money managers can also exhibit a local bias, sometimes due to a belief in superior local information asymmetry or specific mandates.¹

4. How does technology impact localism?

Technology has generally reduced the barriers to global investing, making it easier and more cost-effective to access information and trade securities across borders. The availability of online brokerages, global ETFs, and financial news from around the world theoretically mitigates the information advantage of local investments. However, the psychological roots of localism mean that despite technological advancements, the bias can persist.