Home Bias and the Best Time to Diversify

By Charlie Bilello

08 Jul 2021

“Invest in what you know.”

A common piece of advice that’s often taken to heart. Familiarity breeds comfort, and the more comfortable you with an investment, the more likely you are to own it.

Which is another way of saying that our feelings and emotions are the primary drivers of our investment decisions, not data and evidence.

It should come as no surprise, then, to find that “home bias” exists, where investors overwhelmingly favor their country of residence in choosing investments.

Owning Apple, Microsoft, Amazon, and Google (the largest U.S. publicly traded companies) feels less risky to Americans than owning a lesser-known overseas brand.

Which is why if you look at the portfolios of most U.S. investors you’ll find a much higher weighting to U.S. equities than a passive index approach would imply.

Are you home biased? Let’s find out…

If you’re a U.S. investor and you have more than 57% of your equity allocation to U.S. stocks (the current share of U.S. equities as a percentage of global equities), you are indeed making an active, home-biased bet.

And you’re not alone.

Most investors, regardless of where they live and whether they know it or not, are biased in this same way (if not in stocks then in bonds/REITs/etc.). One of the most extreme examples is France, where Pension Funds have an 88% weighting to their home country stocks while French equities make up only 3% of the global equity market.

Data Source: FTSE Russell

While academic studies have shown the benefits of international diversification over the long, long run, investors live in the real world of the short run: their most recent personal experience. And in that world, there will be many times where engaging in home bias actually helps you, as the home country outperforms. When this happens, it only serves to reinforce the natural urge to favor local investments.

The best example of this today is in the United States.

Over the past ten years, U.S. stocks (S&P 500) have gained over 283% versus an 85% gain for International Developed (MSCI EAFE) and a 55% gain for Emerging Markets (MSCI EM). And, U.S. equities achieved this substantial outperformance with lower volatility to boot (13.6% annualized volatility vs. 15.0% for international developed and 17.7% for emerging markets).

Any way you look at it, home bias has helped U.S. investors in recent years. And when home bias helps, it’s extremely difficult to maintain or consider adding to foreign equities.

But here’s the rub. Historically, the best time to diversify into an asset class is actually after a long period of underperformance, not outperformance. Why? Because it is after such periods that assets are more likely to be cheaper and unloved, and buying cheaper assets tends to lead to better long-term outcomes.

Looking a long-term chart of Emerging Markets versus U.S. stocks tells an important story of cyclicality in relative performance. There have been long periods where Emerging Markets have lead and long periods when the U.S. has lead. The most difficult time to add Emerging Market exposure was in the late 1990s, after U.S. stocks outperformed by a wide margin. In retrospect, though, this was the best time, as the subsequent ten years were extremely favorable for Emerging Markets.

Investors are wired to do the exact opposite and often only consider holding foreign equities after they have outperformed for a long period of time (see emerging markets in 1994 or 2010). In chasing past performance, though, they will likely eliminate much of the diversification benefits altogether.

Data via YCharts

The question for U.S. investors today is not whether home bias has helped. It most certainly has. The question is whether it will continue to help going forward. Because no knows the answer to that question (we can’t predict the future), we need to diversify to protect ourselves from the unknown. With different demographics and fundamental drivers, emerging markets
are an asset class that has the potential to look different.

And, if the U.S. doesn’t continue to outperform, holding some assets that look different could prove beneficial.

While that may seem like a low probability outcome today given U.S. dominance in the recent past, we know from history that recent performance in markets tends to be a poor predictor of long-term outcomes.

There is no finer example of this than Japan.

At the end of 1989, Japanese investors were very confident that Japan was the place to be; the Nikkei Index had wildly outperformed the rest of the world, culminating in one of the greatest bubbles in history. Home bias had helped more than ever before.

What would those same investors say today, 32 years later, with a Nikkei Index still 25% below its 1989 peak? That the best time to diversify is when it’s the last thing you want to do.

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Disclaimer: All information provided is for educational purposes only and does not constitute investment, legal or tax advice, or an offer to buy or sell any security. For our full disclosures, click here.

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