From our favorite sports teams to our favorite foods, it’s human nature to prefer what we find familiar. There’s even a name for our local comfort zone. It’s called home bias. We tend to feel the same way about our investments, weighing down our portfolio with more of our own country’s stocks than is warranted. Unfortunately, even if it increases your comfort level, excessive home bias can decrease your odds for investment success.
Home Bias: A Closer Look
As touched on above, home bias is when you load up on your own country’s securities, feeling that because something is more familiar, it’s a safer bet. In many walks of life, the benefits of the familiar are absolutely true. Nothing replaces your tried and true local restaurant, where you already know what you’re going to order. And seeking references remains a fantastic idea in your business ventures. Unfortunately, the same adage does not hold up as well for your investments. Decades of academic scrutiny have revealed a good reason to avoid concentrating your portfolio too heavily in any one country’s securities – including your own. But what that “good reason” is might surprise you.
Crunching the long-term data, developed-country international stocks deliver about the same expected return as U.S. stocks, which makes sense in our global economy. While emerging countries’ stocks have delivered higher returns over time, those returns come at a higher level of risk. So if seeking premium returns from foreign stocks isn’t the key reason to go global, what is? In a word: Diversification.
Global Diversification: The Free Lunch of Investing
By deliberately spreading your investments widely around the world, you avoid concentrating your risk eggs in any one basket, with no expected reduction in the level of returns you’re seeking to achieve in exchange for taking on market risk. That’s why financial author Larry Swedroe has referred to international diversification as “probably the only free lunch in investing.” By building the parts into a whole, they become a unified force that can better protect you against market volatility. This not only evens out your ride, but it can enhance the long-term return of your portfolio.
Swedroe adds: “Since this lunch doesn’t come with any calories, the logical conclusion is to eat as much of it as you can.” How much is right for you? It’s important to point out that some degree of home bias is not only acceptable, but even desirable. There are several practical advantages to potentially holding a greater allocation to U.S. holdings than pure academic theory may suggest:
1. Costs – Investing abroad can be more expensive, especially in emerging markets; expected benefits must be weighed against these increased costs.
2. Tax management – Particularly within your taxable accounts, international investments can generate tax inefficiencies that warrant experienced oversight.
3. Risk tolerance – When international risk appears (think Greece), even stalwart investors may lose heart and abandon their carefully laid plans at just the wrong time. It’s important to seek balance between the benefits of investing internationally versus your personal ability to stick with your plans when the going gets rough. You’ll be doing yourself no favors if you take on more market risk of any sort than you can reasonably tolerate when it occurs.
Speaking of Greece, MSCI recently released country-level returns for the third quarter of 2013 and we couldn’t help but notice that Greece topped the list this quarter among developed and emerging country markets combined, delivering 26.3 percent quarterly returns. Spain was not far behind at 25.9 percent. U.S. returns were 6.4 percent during the same period. That’s not to say anyone should be bulking up on Greek and Spanish stocks based on this tiny snapshot, but it illustrates the importance of diversification, sometimes into where you may least expect the rewards to be found.
It’s a Small World, After All
It’s worth noting that home bias is not limited to our own home. Investors around the globe tend to over-invest in their country’s securities – in fact, to even greater degrees. Admittedly, this is in part because U.S. capital represents nearly half of the total world market, which makes it much easier for an American to invest heavily in U.S. stock and still not exceed a balanced weight within the global market. That’s not as easy for, say, our counterparts in the U.K. whose capital weight is closer to 7 percent in the global market.
In short, whether you’re an American or a Brit, Australian or Malaysian, by going global with a portion of your investments in a well-diversified portfolio, you can expect to better manage your exposure to the risks involved in achieving the expected returns you seek. In our estimation, that’s an advantage worth traveling abroad for.