JumboCash: The 'home bias' in investing

When we talk about stocks and “the market,” we usually think about the American market — companies listed on the New York Stock Exchange and the Nasdaq. A local focus pervades into the portfolios of American investors, who tend to invest the majority of their equities in domestic companies. In fact, across the world, investors have a “home bias”: a tendency to invest most of their equity in stocks from their own country. However, increasing diversification across the globe allows investors to reduce their exposure to risk.

There are a variety of reasons investors tend to focus on their home country. Mainly, investors feel a sense of familiarity by investing in what they “know.” There are common misnomers related to familiarity: that investing in companies you’ve heard of — think name brands like Nike, Walmart and Starbucks — will lead to higher returns. There is no quantitative evidence to defend this fallacy, but because it feelsbetter and safer, we prefer it.

For Americans in particular, we know we have the world’s strongest economy, but we might not understand how it fits into a global context, leading us to invest a large portion of our portfolio in U.S. stocks. A good way of understanding the role of the American economy within the world stage is by looking at its share of world market capitalization. The market capitalization (typically shortened to “market cap”) is the price of a company’s stock multiplied by the amount of shares outstanding; hence, market cap provides a measure of the company’s value by telling you the hypothetical cost of purchasing all its shares. When looking at the country level, the market cap for any country’s stock market shows what portion of the global stock market the company constitutes. 

Since 1970, the U.S. stock market has ranged between 30–60% of the global market cap.For the past five years, the U.S. market has accounted for about 50% of the global market cap. So, if you bought only U.S. stocks, you would limit yourself to only half the existing market!

The first key implication of the “home bias” is a heightened exposure to risks. By only investing in stocks from your home country, you overexpose yourself to risks specific to that country. With global diversification, you effectively buffer yourself against risks related to your home country.

Due to globalization, increasingly interconnected economies and the presence of multinational corporations, you might believe the U.S. stock market is already globally diversified enough. Well, it is true that in 2015 44.3% of the revenue of S&P 500 constituents came from foreign countries. However, the sectors of the U.S. economy differ from those of other nations across the world. For example, if the information services sector flopped in a given year, but the materials industry thrived, you would be especially hurt by investing in an economy that favors the former over the ladder.

No matter where you come from, remember to overcome the familiarity of investing only in stocks from your home country. Global diversification allows you to reduce volatility and access the returns of foreign markets.