What is home country bias? How can it hurt your investment performance? How do you recognize it? How can you neutralize it?
At the time of this writing, we expect higher returns from non-US stocks than U.S. stocks. We are writing this out of concern that home country bias may hurt investors’ performance. We stop short of saying that investors shouldn’t be biased; rather, we believe investors should be conscious of home country bias and comfortable with its effects if they are going to be biased.
What is home country bias (HCB)? It’s the tendency for investors to prefer investments in their domestic market. For example, U.S. investors tend to prefer U.S. investments.
How prevalent is HCB? According to a study by Vanguard, U.S. investors have about 80% of their equity investments in the U.S. despite the fact that U.S. equities are only about 50% of the global equity market. This is also true globally: Australians allocate 66% of their investments to their home country versus a global market weight of 2%; in Japan it is 55% versus 7%; in the U.K.it is 26% versus 7%.
Why might a HCB hurt you? When U.S. stocks underperform markets in other countries, over-weighting U.S. stocks will detract from your performance. That’s pretty obvious. Some will also argue that global diversification is less risky than concentrating on your home market. That may be, but the advantage is small given that the U.S. market has historically tended to exhibit less volatility than foreign markets. Of course, HCB helps your portfolio when the U.S. market is outperforming.
Here are the ten year return expectations from Research Affiliates as of July 31, 2017:
|U.S. Large (S&P 500)||2.6%|
|Emerging (a.k.a. Developing)||8.7%|
International developed includes countries such as Germany, France, Japan and the U.K. Emerging includes China, Russia and Brazil. Source: Research Affiliates
A global stock investor holding 50% US, 40% international developed, and 10% emerging (which is close to the global market value weights) would have a 5.3% expected return as compared to an investment in the S&P 500 with a 2.6% expected annual return. If the investor has 60% of their portfolio in equities, they would expect an additional 1.6% annually. This increased return would add about 15% to an investor’s portfolio (before taxes and inflation) over the 10 years due to compounding.
Why a HCB might be right for you? Even if the absolute return and risk is expected to be lower, you may still choose to tilt toward the U.S. for a variety of reasons. Doing so may make you feel better or safer or satisfy patriotic wishes. While you may not actually be safer with your bias, you may feel that way just as people may feel safer in a car than a plane.
How to tell if you have a home country bias? If you compare your performance to the S&P 500 or Dow indices without consideration of international stocks, you clearly have a bias. Technically and mathematically speaking, you have a bias if your weight to U.S. stocks exceeds the weighting of U.S. stocks in the global market.
Why only discuss the bias related to equities and not fixed income? In our case, we use fixed income mainly to control risk. Investing in U.S. bonds avoids currency risk. Additionally, many of our clients are taxable and municipal bonds offer tax advantages that foreign bonds do not. We will consider non-US fixed income in portfolios, but generally these are substitutes, at least to an extent, for equities.
What should an investor do? Our recommendation is to consciously select a benchmark that reflects your preferences. If your preference is for the best investment performance and you permit global investments, then your equity benchmark should be a global stock index such as the MSCI All Country World Index (ACWI). At this time, the exchange traded fund based on this index (the ticker is ACWI) has a weighting to the US of about 50%. If you are uncomfortable with this weight, then you can select a blend of indices that represents the U.S. (e.g., the S&P 500 or our preference the Russell 3000) and an index of non-U.S. stocks (e.g. ACWIxUS). For example, one might choose an allocation of 75% to the Russell 3000 and 25% to the ACWIxUS. After establishing a benchmark, one can then tilt their portfolio according to one’s expectations about the markets.