Economists can’t explain why investors everywhere overweight their home market; psychologists, however, just might have the answer, writes Stefan Van Geyt, Group Chief Investment Officer at KBL European Private Bankers (operating in the UK as Brown Shipley)
It’s a well-documented fact that individuals worldwide tend to invest disproportionately in stocks listed in their native country, a phenomenon known as the “home bias puzzle.”
Given the proven benefits of diversification and easy availability of global data flows, this trend has left economists scratching their heads for decades.
Consider the UK. The country has a global index weight, or share of total world market capitalization, of about 8%. Yet the British hold almost 30% of their equity investments in domestic shares.
Or take South Korea, which has a global index weight of less than 2%. Residents there nevertheless make 90% of their equity investments in the domestic market.
Even the United States, with a massive global index weight of almost 40%, is guilty of home bias – with American investor holdings in domestic equities standing at approximately 80%.
Such bias is found, to a greater or lesser degree, in every single market worldwide. The trend is especially pronounced in emerging markets – where there are often structural barriers to overseas investment – and is least evident in Europe, especially since the introduction of the common currency and elimination of exchange-rate risk.
Between 1997-2004, the level of home bias in the eurozone declined by 9%. Over the same period, the level of regional bias (meaning total investment in eurozone shares) increased slightly.
Within Europe, the Dutch, who have long embraced an international equity investment strategy, are by far the least exposed to home bias, with slightly more than 20% of equity investments allocated to the domestic market. That sounds pretty balanced – until you consider that the Netherlands represents less than 1% of total world market capitalization.
Like the Netherlands, Austria, Belgium and Germany also at first appear relatively unbiased, with roughly 37%, 45% and 48% of their equity investments in domestic shares. Once again, though, this has to be put in context: Germany, the largest of the three markets, has a global index weight of barely 3%.
The trend is even more exaggerated in France, which has a global index weight of 3% and where residents there nevertheless make 60% of their equity investments in the domestic market.
While each of these countries compare favorably to the international mean, being better than average obviously remains far from ideal.
Over the past two decades, nine out of the ten best-performing stock markets have been in emerging markets, according to Bloomberg data. Yet relatively few investors have much exposure to Brazil, Kazakhstan or Peru (the world’s three best-performing markets in 2016).
Given the governance gaps and political risks in many emerging markets, it’s understandable that not everyone wants to buy Kazakh shares. But why does this larger issue persist?
It may pain economists to admit it, but the value of geographic portfolio diversification is simply no match for human psychology.
Think of sports fans, who often form profoundly intense attachments to their team. Very rarely is that attachment founded upon rational deliberation, objective research or any kind of considered personal preference.
Instead, we simply root for the team based in the place we call home.
In fairness to such fans, nearly all of our core beliefs are similarly arbitrary. That includes, at least partly, when it comes to investing – which is why we overweight our own market, despite all the evidence that says we should do otherwise.