Home bias – the tendency to be overweight on domestic securities – is prevalent among retail and institutional investors. Investors are choosing home sweet home, and for good reason! But what are the benefits of home bias? And which asset classes should you use to express your home bias?
Home bias statistics show that (equity) investors prefer to invest in their home markets. For example, U.K. investors were holding 50% of their portfolio in U.K. companies in 2010, down from 72% in 2001. This is a very strong home bias given that the U.K. stock market represented just 5 to 10% of the world stock markets in those years. U.S. and other investors also have a strong bias toward buying local stocks and bonds. This goes against the wisdom of being globally diversified. But are there any benefits to having a home bias? And what asset classes should you use to implement a home bias, if at all?
To know if a home bias is beneficial and to implement the right amount of home bias, you should look at the investment objectives. Investing is rarely just about ‘making money’, although that is part of it. An investor wants to use their investments to secure the financial future of themselves or their institution.
An investor should not want to be overly exposed to their home country. If their home country suffers economically, they are likely to suffer investment losses over the same period if they are mainly exposed to their local market. Financial malaise at home and poor investment returns would strike at the same time for those with a strong home bias.
On the other hand, if there is an economic boom in the home country and the investor is not invested in the home country, then local prices might show a lot of inflation while investors’ foreign investments don’t keep up. The investor would be left with higher prices but not with similarly high investment returns.
If you were to hold the ‘average’ equity portfolio, the All-Country Wold Index (ACWI), then your stocks would be 55.1% U.S. companies, 7.5% Japanese, 5.4% British, 3.5% French, 3.4% Chinese, and 25% other countries (see picture on the right). This looks like a fine asset allocation if you live in the U.S., but other countries only get a small representation. Someone in France or China may want to add a home bias in order to benefit from an expanding local economy to compensate for rising local prices.
For investors, times when the local economy is crashing are also the times when they need to rely on their investments the most. For this reason, you may also want to buy insurance on your local stock index. An investor may buy some deep, out-of-the-money put options which pay out if the local index crashes, say, 30% or more. The put options give insurance that if there is local financial crisis, then you get a payout.
Although it may seem paradoxical, non-U.S. investors may want to be somewhat overweight on the local stock market, while at the same time also be betting (hedging) that there will be a crash in the local economy. This protects the investor from positive and negative extremes in the local economy.
Bonds, Cash, and REITs
Bonds, cash (in the form of short term bonds, CDs, or even bank accounts), and Real Estate Investment Trusts (REITs) are seen as a hedge against equity market volatility. Looking at the Global Aggregate Bond Index of government and corporate bonds, we see that US Dollar debt makes up 45% of the global bond market, the Euro 25%, the Japanese Yen 17%, and so on. This means that there is always a lot of currency risk if you buy global bonds. Even if your local currency is the US Dollar, 55% of your bond portfolio will be denominated in other currencies. This is a lot of foreign exchange risk to take on. The following charts show the currency volatility for the main currencies (select USD/Euro, JPY/Euro, or GBP/Euro in the top bar):
This currency volatility means that the global bond index will also show significant volatility – and it is not clear that the risk-adjusted returns are better for it. While geographic diversification may reduce the volatility of an equity portfolio, geographic diversification is likely to increase volatility for a bond portfolio. This means that for bonds and cash, investors should have a very strong home bias. But there is also a potential danger if you only buy local currency bonds….
For bond investors, inflation-adjusted return is typically extremely negative if the currency sees major price inflation after the purchase of the bond. What a globally diversified bond portfolio would offer is protection against (runaway) inflation in the local currency. But a better way to deal with inflation risk is to buy inflation-linked bonds, which are available in most currencies. (Or buy insurance against inflation). Inflation-linked bonds offer a fixed inflation-adjusted return as opposed to a fixed nominal return.
For bonds, it is prudent to have a very strong home bias, but at the same time to also buy inflation-linked bonds. A bond portfolio might then be 50% nominal local currency bonds and 50% inflation-linked local currency bonds.
REITs are another semi-fixed income asset that behave similarly to bonds, and the same currency dynamic applies. But REITs also represent the real estate market. Owning local REITs can function as a hedge against rising local home prices. This can be a benefit to investors who don’t yet own their homes: if local home prices rise, their investment returns from REITs should rise as well. Similarly, if home prices fall and an investor’s REITs go down in value, then the upside is that the next home purchase will be easier.
For REITs, as well as for bonds, it makes sense to have a strong home bias.
Your Home Bias
I recommend that you have a small home bias in stocks iff you don’t live in the United States, so local stocks should make up at least 20% of your stock portfolio. If you live in Europe, then you could achieve this by buying some world-index of stocks, plus a Europe specific index. For Europe, I would consider the Stoxx Europe 600 to be a good example of local stocks. If you want to get more specific, you could consider buying the FTSE 100 if you live in the U.K., the EMU index if you live in the Euro Area, or the MSCI Nordic if you live in one of the Nordic countries. Similarly, you could buy Asian or Latin American indexes if you live there.
Home bias for bonds, cash, and REITs is more important than for stocks, in part because they represent safer asset classes. The currency volatility that you would get by (currency) diversification of bonds, cash, and REITs creates volatility in your portfolio. But this higher volatility does not help you get higher returns. Therefore, for these three asset classes, you might as well be fully invested at home.