In Defense of Home Bias

I ordinarily like the writings of Jason Zweig, so this post is not meant as a criticism of him.  He wrote an interesting article suggesting that US investors may suffer reduced performance because they invest too much in US stocks.  Ideally, shouldn’t investors seek out the stocks that are likely to perform the best, regardless of where they are located in our world?

Ideally, yes.  Practically, there are difficulties.  I write this as one who has always allocated more than the average to international stocks.  Investing internationally assumes several significant things:

  • There will be no war that changes the amount or terms of commerce.
  • There will be no legal changes that affect property rights abroad.  This includes exchange controls.
  • I will get the same flow of news that an investor in the target country will get.
  • I understand the differences in the accounting rules, and will not get tripped up if they are more liberal than in the US.
  • I understand that regulations are different in foreign countries as well.
  • Transacting in non-ADR foreign stocks from the US can be expensive for retail accounts.  Buying mutual funds that invest in foreign stocks carries expensive management fees.
  • Economic policy will remain rational in the target country, or at least, better than that of the US.
  • I understand the trading nuances of the target country.

Home bias is normal, around the globe.  We understand the business dynamics of our own countries far better than foreign countries, together with our understandings of accounting, regulation, exchange controls, information disclosure, legal systems, economic policy, etc.

Even within the US, there is home bias among investors to the extent that we tend to invest more in companies that are near to us — perhaps it is a greater flow of informal information.

I would encourage all of my readers to invest abroad but to do it selectively.  Does the country allow for relatively free capital flows?  Do they honor the rule of law?  Is their accounting as good as that in the US?  Are there war risks?

There are risks in investing abroad that do not exist locally.  Make sure you minimize those risks if you invest abroad.

5 Comments

  • J K says:

    The last question you pose: “Is their accounting as good as that in the US?”, probably should have been phrased “Is their accounting any worse than that in the US?” Quality of accounting means little if the precepts are openly flaunted (see Enron, AIG, widespread mis-valuation of Level 3 Assets, etc.)

    Same applies with the rule of law. One might ask GM bondholders about adherence to the rule of law in the US. Same with US banks being ‘coerced’ to renegotiate once ‘legal and binding’ mortgages.

  • Bob_in_MA says:

    What’s interesting now is that much of the punditry has a BRIC bias, almost to the point of absurdity. People like Jim Rogers and Marc Faber were spot on in their criticism of the financial system here, but they are certain that growth will excuse any sort of fallout from the lending spree going on in China now. It reminds me of the 1980s when Japan was repeatedly offered as an example of a better managed economy. Then 15 years later, things didn’t look so good.

    I have a feeling that in another few years, American investors will have a more pronounced home bias. The question is, will it include equities? ;-)

  • matt says:

    Another reason for the home bias (in the United States case) is because of the liquidity in the capital markets here. During crises, liquid markets become the recipients of capital.

    I wouldn’t put too much stock in the rule of law in the United States. The rule of law only applies when it benefits the oligarchs. I noticed dozens of events over the past two years in which the Feds were veritable gangsters. It shocked my confidence in the rule of law in this country.

  • dWj says:

    Many of these points don’t really defend the home bias per se. If war is more likely to affect the foreign country than one’s home country, that’s a reason to favor one’s home country, but it’s also a reason for those foreigners to prefer one’s home (their foreign) country. If the risks for the countries are even comparable, the diversification against what is to some extent a tail risk is a powerful argument against home bias.

    The best reasons for home bias are the informational ones you mention and the fact that one’s desire to spend is likely to correlate more strongly with the performance of one’s own country (and even sub-country region) than that of other countries. If the dollar drops, causing prices to rise, consumer prices will tend to rise less than foreign currencies do (as priced in dollars), and U.S. stocks will tend to keep up, while if the dollar rises, foreign currencies will drop. If the U.S. economy slows down or speeds up beyond what is expected, then, particularly insofar as your wants are driven by watching what your neighbors are buying, your spending needs (wants) will drop or rise, respectively. In trader parlance, you’re overhedged by investing in foreign stocks. It makes sense to put some money in foreign stocks for diversification against certain kinds of risks, but you certainly shouldn’t expect to hold the same portion of home stocks in your portfolio as your country’s total market cap makes up of the world’s.

  • People want to earn quick money. Thats what makes investors invest more in companies that are near to us. I would love to invest outside but sometimes I fear the ominous change that would happen if i invest in a foreign land.