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Leaving Home-bias At Home

May 25, 2017

Everybody loves the comforts of home, but investors who become too anchored to familiar territory can end up with a very narrow view of the world.

Home bias, the tendency of investors to allocate a disproportionate amount of their funds to their domestic market, is a well-documented phenomenon.

There can be rational reasons for home bias. New Zealand investors, for instance, have the advantage of dividend imputation. This is where firms that have already paid income tax on profits attach tax credits in distributions to shareholders.

A second understandable reason they might tilt to their home market is familiarity with the companies they are investing in. Companies like Westpac, ANZ, Fletchers and Air New Zealand are household names and are frequently in the news.

A third justification might be that a home bias satisfies an individual investor's particular goals or risk appetite. These are all issues for an advisor to consider.

But a large home bias also can have undesirable consequences. Those consequences relate to the risks of a portfolio ending up with very concentrated exposure to individual countries, companies and sectors.

Dividing Up the World

This is particularly the case where your home market is relatively small in a global sense or where it is dominated by one or two sectors.

Chart 1 shows the natural weights of some of the countries in the MSCI All Country World index, a popular benchmark for the global share market. You can see the US is by far the biggest market, with a weight of more than 53% as at 31 January 2017.

Japan is a distant second with a weight just above 8%, then the UK, Canada, France and Germany, China and Switzerland. Australia is ninth with a weight of 2.4%, while New Zealand is in 36th place with a weight of just 0.1%, too small to see on the chart.

Too much home bias can represent a pronounced deviation from the global market portfolio and leave you taking unnecessarily big bets. For instance, Canada was the best performing developed market in 2016 with a gain of more than 25%. But with too much home bias, the weight to Canada would be significantly reduced, adversely affecting your overall return.

Since we have no reliable way of predicting which country will be the best performer year to year, it makes sense not to deviate too far from the market portfolio.

Dividing Up the Sectors

Having a sizeable home bias means not only taking a big bet on a single country, but ending up with a disproportionate exposure to certain sectors.

Using Australia as an example, the big four banks (Westpac, ANZ, CBA/ASB and NAB/BNZ) represented nearly 28% of the market, as of early 2017. Financials overall made up 38%, while materials stocks represented 17%. In other words, two sectors made up more than half of the market.

To put that into perspective, financials represented just 19% of the global market while materials had a share of just 6%.

Another way of looking at this bias is to consider which sectors are poorly represented in Australia. For instance, information technology stocks made up just 1.3% of the local market, compared to 16% globally.

Dividing Up the Stocks

We've seen that a home bias means concentrated bets on a single country and a couple of sectors. So it shouldn't be a surprise that it also means you end up taking outsized bets on a handful of stocks.

Again, using Australia as an example, assuming a 60% Australian home bias, a single stock—the Commonwealth Bank, which owns ASB here in NZ—will represent nearly 6% of your portfolio. That is more than the weight of the UK and Japan combined or more than your entire holdings in emerging markets.

Put another way, the top five stocks (the four big Aussie banks and BHP Billiton) will make up more than 20% of the portfolio. It would also more than halve its exposure to big overseas names like Apple, Microsoft, Amazon, Vodafone, Nestle and Volvo.

In fact, of the top 50 stocks in this Australian-biased "global" portfolio, all but four are local stocks, the exceptions being Apple, Microsoft, Exxon Mobil and Amazon.

Putting it All Together

Given investors tend to source most of their income from their home nation and hold most of their other assets there, you can see that this degree of home bias represents a very big bet on one country, a couple of sectors and a handful of stocks.

So the question then becomes what degree of home bias is acceptable. It shouldn't be surprising that there is no one right answer to that. It depends on each individual investor's tastes, preferences, circumstances and goals.

A good approach is to use a global market portfolio as your starting point. If you want to increase the expected return of your portfolio, you can use information in current market prices and company fundamentals to tilt your portfolio towards stocks with higher expected returns. Research has shown that small caps, low relative price and high profitability stocks deliver a premium over the market return.

While you may tilt your portfolio towards New Zealand for the imputation credits or your familiarity with the stocks, it's important to understand this has nothing to do with the expected return of your portfolio. It is just a preference. But it also comes at a cost.

In contrast, broad global diversification creates a portfolio that spreads its risk to more economies, to a greater number of stocks, to a wider range of companies and to a wider spread of sectors.

Again, there is no single right answer in terms of asset allocation. It will depend on the individual investor's circumstances, goals and risk appetite.

At some time or another, we all have to leave home.

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