Home bias, in the context of finance and investing, refers to the tendency of investors to allocate a disproportionately large portion of their investment portfolio to domestic or local assets, such as stocks and bonds, rather than diversifying their investments across a broader range of international assets.
In addition to an international level, the existence of home bias has also been highlighted at a local level,, for example by Coval and Moskowitz (1999) where they proved that funds in the USA prefer investments that are geographically closer to the fund itself and its operations. (Sercu & Vanpée 2007).
When a portfolio, or rather its manager, suffers from home bias, it often results in a too high exposure to domestic securities, which leads not only to the loss of the benefits of diversification, but can also significantly increase the risk of the portfolio. (Aguilar 2021)
Key mechanisms linked to Home Bias
- Comfort and Familiarity: Investors tend to feel more comfortable and familiar with the companies and economic conditions in their own country. This familiarity can lead them to favor domestic investments.
- Perceived Safety: Some investors perceive local investments as safer due to their proximity and familiarity, even though global diversification can potentially reduce risk.
- Information Asymmetry: Investors may have better access to information about local companies and markets, leading them to believe they have an information advantage.
- Regulatory and Tax Considerations: Local regulations and tax incentives can influence investors’ decisions to allocate more funds to domestic assets.
- Currency Risk: International investments involve currency risk, which can impact returns. Home bias might result from a desire to avoid this risk.
- Herding Behavior: The tendency to follow the investment decisions of others can contribute to home bias, especially if others are also exhibiting the same bias.
Implications of Home Bias
- Lack of Diversification: Failing to diversify internationally can limit the benefits of spreading risk across different markets and economies. If the domestic market experiences a downturn, the portfolio may be more heavily affected.
- Missed Opportunities: Neglecting international opportunities means missing out on potential gains from well-performing markets and companies abroad.
- Reduced Returns: If the domestic market underperforms relative to global markets, a home-biased portfolio may experience lower returns.
- Increased Risk: Concentrating investments in a single market increases exposure to local economic and political risks.
How to mitigate the impact of home bias?
- Diversify Internationally: Consider allocating a portion of your investment portfolio to international assets to take advantage of global market opportunities and reduce risk through diversification.
- Educate Yourself: Learn about international markets and companies to become more comfortable with investing beyond your home country.
- Consult Professionals: Seek advice from financial advisors or professionals who can help you design a well-diversified portfolio that aligns with your risk tolerance and investment goals.
- Long-Term Perspective: Focus on the long-term benefits of diversification and understand that short-term fluctuations are a normal part of investing.
Home bias is a psychological bias that can impact investment decisions and portfolio performance. By recognizing this bias and actively taking steps to diversify globally, investors can potentially improve their investment outcomes and manage risk more effectively.