PRAXIS MAKES PERFECT
Why does home country bias exist in investing—and what should you do about it?
By Linda Leitz
If you needed to pick individual stocks for a portfolio from a limited list of choices, would you rather invest in GE or Philips? Kroger or Ahold? Hershey or Guylian? Dow or BASF? If you chose the first member of each pair, which is a U.S.-based corporation, unlike the other member of the pair, you have lots of company.
Many investors would choose the U.S.-based companies over the international companies. This is an example of what’s known as home country bias, home bias, or home equity bias, a topic explored by Joy Clady, Ph.D., CFP®, financial planning lead and department chair of finance at Grand Canyon University, in an unpublished paper entitled “Home Equity Bias of Individuals, Institutions, and Financial Planners” (2014). Her review of available data and literature on this topic shows that individuals in the U.S. tend to invest their portfolios heavily at home. Their investments are often around 80% in domestic holdings, which is far below the less than 60% of the global equity that U.S.-based companies actually account for.
This home country bias isn’t limited to individual investors. It’s also present in institutional investing and in portfolios managed by professional financial advisors. For instance, when we look at the investment choices in our clients’ 401(k) plans, the majority of the funds are domestic (though some international investments are available). In his book What Investors Really Want, Meir Statman points out that this myopia can be found elsewhere, too: “American investors overload their portfolios with American stocks and Chinese investors overload theirs with Chinese stocks.”
Research has uncovered three main reasons for home bias, and understanding these issues can help you work with clients to overcome them.
Reason 1: stress around money
Sonya Lutter, Ph.D., CFP®, and founder of EnLite, says money and financial decisions are stressful for many people, and “When there is stress, we rely on what is familiar and comforting.” It’s more comfortable to invest in companies in your home country.
To combat this, let’s ask ourselves what’s driving investors’ fear of expanding their portfolios geographically. Lutter says investors might be reacting to biases based on their own unique experiences, and investors might have some underlying experience or fear spurring their reticence to invest internationally. This may be particularly true in light of current global conflicts. We should explore those feelings when we begin working with new clients. Better understanding our clients’ fears, desires, and biases allows us to better customize the financial planning advice we provide them.
Reason 2: familiarity
Along with the mantra of diversification is the admonition to “invest in what you know”; these two principles of investing seem to conflict with each other. Most individuals feel like they know more about companies in their own country than outside it.
But this may not be true. First, as Wes Crill, head of investment strategists at Dimensional Fund Advisors, tells us, “Investors viewing non-U.S. stocks as the great unknown can take comfort in the fact that many household names trade on non-U.S. exchanges. After all, who isn’t familiar with products by Nestle, Samsung, or Anheuser-Busch?” It helps when we inform clients that ownership of those well-known firms is based outside the U.S. Second, information access has advanced so much in the last 20 years that data on large international corporations and major economics truly compares with those of the U.S.
Reason 3: patriotism and a sense of national stability
In addition to familiarity, loyalty and devotion to one’s own country can affect investment choices. This also ties to Lutter’s observations about current global tensions, which may produce distrust of certain countries and ethnicities, and could ultimately affect investment choices.
The leaning toward one’s own country is compounded by concerns about risks specific to other countries. During the Great Recession of 2008–2009, several countries suffered from major economic problems that did not extend beyond their borders. At other times, localized economic challenges have led to fluctuations in currency values for individual nations, which can increase the desire to keep investments close to home. As advisors, we generally accept that individual nations will have issues to specific them and that each country has currency risks and inform our clients accordingly.
How advisors can foster global diversification
While our clients come to us for guidance, Lutter points out that we should be cautious of placing our judgment ahead of the client’s judgment. Our role as advisors is to provide information and direction, but not to judge. This can be particularly important in implementing investment recommendations for advisors who have discretion over investments.
Establishing and documenting parameters in the initial stages of establishing a client’s investment policy and overall strategy is critical. Exploring client biases and concerns, addressing them with compassion and education, and moving forward with what the client is comfortable with can help our clients broaden their global equity positions.
Clady advises, “Often, gains in familiarity would likely need to be initiated by the financial planner. A financial planner is unlikely to be able to influence local media coverage or advertising of distant companies, but perhaps newsletters, discussions, and online blogs could be used to help clients become familiar and comfortable with foreign firms.”
Know thyself first
And there’s one more very important point to keep in mind. Before we can educate our clients and address their concerns about asset allocation that more closely match global markets, we need to address our own biases and habits in this regard.
We’ve all had new clients come to us with an over-allocation to employer stock. Why do we see this so differently than portfolios that are heavily weighted toward domestic stocks? Clearly, a portfolio of U.S. mutual funds and ETFs doesn’t have the same risk as an excessive allocation to a single stock. But there are some similarities. The single stock can be affected by its industry and management. And if it’s stock in the client’s employer, there is additional risk to personal earned income if the company has rocky times. The risk of having all stocks in the same economy tied to the same currency can also have similar risks on a smaller scale. A macroeconomic downturn could lead to declines in a portfolio at a time that income is in jeopardy.
Besides limiting downside risks, Crill touts the upside of a globally diversified portfolio: “Investors who are only focused on U.S. markets are missing out on a literal world of opportunity—thousands of securities worth trillions of dollars—just waiting to provide diversification benefits.”
After all, our fiduciary duty isn’t only to reduce risk. In CFP Board’s Code of Ethics and Standards of Conduct, the definition of financial planning is, in part a “process that helps maximize a Client’s potential for meeting life goals.” The diversification of risk through the inclusion of broader global investments in investment allocation can both reduce risk and provide good returns.
As Clady posits, “Truly embracing the tenets of diversification, planners would not wonder whether it is risky to invest internationally; instead, the conversation would begin with the notion that it is risky to concentrate investments on the home country.” The global nature of the economy suggests that diversifying the risks and finding the rewards in global investing is providing good service to our clients.
Linda Y. Leitz, Ph.D., CFP®, EA, is a NAPFA-Registered Financial Advisor in Colorado Springs, CO.
image credit: istock.com/filo