Is There Really No Place Like Home?
Emotions is something which should stay out of investment decisions as it often leads to human biases, which in turn can be harmful for the investments. The bias investors experience the most is home bias; a tendency to favor investments that are familiar.
By Martina, co-founder of Bifrost - Jan 24 2019
What is Home Bias?
Home bias is a type of bias an investor has when investments, such as bonds and shares, are favored and invested in a large number of domestic equities. With the multitude of variations, people are drawn towards the familiar as it seems inherently less risky. However, by putting all eggs in one basket, the risk actually increases. This is because of the correlation between a company’s performance in shares and the domestic market it operates in. Thus, less risk and larger return can be achieved through diversifying investments.
Diversification aims at maximizing returns by investing in different countries, asset types, and industries. There are multiple benefits of choosing a mix of investments, and the key to long-term investment success lays in maintaining that mix. The main benefits of a diversified portfolio is not necessarily to boost performance, but to target a risk level based on time horizon, tolerance of volatility, and goals which could result in higher returns. When an investor does not diversify their investments, they will not only have higher risks, but they may also miss opportunities in faster-growing markets. Despite the many benefits of diversification, a large number of investors in all levels of experience still invest heavily in their domestic market.
Reasons why people are biased?
One major reason why investors make biased decisions is the difficulties in making foreign investments, including transaction costs and legal restrictions. Another reason which fosters bias is the sense of familiarity, where investors tend to favour the known over the unknown. One reason for this is that a lot of investors believe that their own country will deliver large returns. Another reason is the global uncertainty regarding the political-, economical-, and societal landscapes.
The home bias is a phenomenon common all over the world. An academic study from the 1980s showed how Swedes would put almost all their money into the Swedish market, despite the capitalization representing only about 1% of the world.
In order to overcome this home bias, one must begin looking into foreign investment opportunities. This goes beyond looking into multinational corporations as their performance is still quite tied to the domestic market. There are industries, such as health and transportation, which are doing well all over the world and knowing in which country these will foster over the next years is impossible. Thus, owning investments in these industries all over the world will improve the chances of investment success. The best investment success can be achieved by increasing our opportunities, rather than limiting them.