Yahoo Finance The Dangers of Investing With a Home Bias
When Americans talk about the stock market, they're generally referring to the Standard & Poor's 500 index or the Dow Jones industrial average. That's understandable, particularly when it comes to the S&P 500, which represents about 80 percent of U.S. market capitalization. Because it's a widely diversified measure of the domestic stock market, the S&P 500 has become the de-facto benchmark for most U.S. investors.
But does that mean it's the best benchmark?
Financial advisors who advocate global diversification note the S&P 500 doesn't include companies domiciled outside the U.S. As such, it represents only one part of the available investing universe. The total U.S. stock market, including companies of all sizes -- not only those in the S&P 500 index -- makes up about 50 percent of global market capitalization.
But a February 2014 Vanguard report found that, on average, U.S. mutual fund investors had only 27 percent of their equity holdings allocated outside the U.S. If their portfolios were balanced according to world market capitalization, about half of their assets would reside in non-U.S. stocks.
The tendency to invest disproportionately in one's own country is known as "home bias." It's hardly unique to the U.S., however. Vanguard research released in 2012 also identified home bias among investors in Canada, Australia and the U.K. Asset managers and researchers don't say investors' portfolios must necessarily track world-market capitalization to the tiniest decimal point, but they do recommend diversifying beyond one's home country.
David Larrabee, director of member and corporate products at CFA Institute in Charlottesville, Virginia, says investors tend to lean toward the familiar. In addition, he says, they often believe stocks from their home country will outperform other regions. In the U.S., that belief has been rewarded over the past six years, as domestic stocks outpaced many other global indexes. However, many investors with diversified portfolios have been frustrated that their returns were lower than the S&P 500 index.
But that doesn't mean investors should move out of international investments and back into U.S. stocks, Larrabee says. CFA Institute, which conducts financial research and administers the chartered financial analyst program, has identified specific ways home-country bias can hurt returns over longer time frames.
"You're getting less diversification in your portfolio, and as a result, your portfolio is likely to have greater volatility and realize lower returns. There's also opportunity cost. By not investing outside your home country, you pass up opportunities to invest in faster-growing markets where valuations might be more attractive," Larrabee says.
Krishna Memani, chief investment officer at Oppenheimer Funds in New York, says U.S. market outperformance has made the argument against home bias more difficult.
"When emerging markets or European companies servicing emerging markets were growing very rapidly, and all those markets were going up, it was an easy thing to say to people. But over the last five years, because U.S. markets have done so much better, this mantra of diversification has become somewhat stale in investors' minds," he says.
David Lyon, CEO of advisory firm Main Street Financial in Chicago, says the sheer ubiquity of the S&P 500 index means U.S. investors need constant reminders about diversification's benefits. He says investors should remember that the ongoing barrage of S&P 500 updates are simply news reports, not financial advice.
Performance of any index doesn't take real-world portfolio factors into account, he adds. Investors can't directly buy an index, so they must get exposure through an exchange-traded fund or mutual fund that tracks an index. Those fund investments include expenses, dividends, taxes, tracking error and other factors not taken into account by a daily index report.
"All those things point to why positioning or benchmarking yourself against an index is not a good idea," Lyon says.
Rather than focusing on one domestic index as a benchmark, investors should take a global perspective as their baseline, he says.
"Your portfolio diversifies risk on a number of levels," he says. "Even as circumstances may drag down one part of your portfolio, identify how other parts counteract that."
While U.S. stocks have performed like champions in recent years, it's also become increasingly easy to invest overseas. Dan Egan, director of behavioral finance and investing at robo-advisor Betterment, says previous generations had a tougher time allocating outside the U.S. In recent decades, inexpensive mutual funds and ETFs have opened the door to global investing.
"We're in a different world than 20 or 30 years ago in terms of how easy and effective it is to invest in an index-tracking manner internationally. It used to be more expensive, and it was harder to know what good-quality companies and indices you could track. There were not low-cost investment vehicles to to do it," Egan says.
Egan notes that home bias can be narrowed down to a very granular level, and even professional investors are not immune. For example, 2012 research from Indiana University, "No Place Like Home: Familiarity in Mutual Fund Manager Portfolio Choice," found that U.S. mutual fund managers tend to invest more heavily in stocks from their home states.
Egan says investors should be cognizant of their own degree of home bias. "Imagine being an individual who happens to live in California, and saying, 'The California stock market is my benchmark because I live here.' Well, that doesn't make any sense when you can invest in all the companies across the U.S.," Egan says. "But you're doing the same thing, a little bit, when you say, 'I'm only going to benchmark to the S&P 500.' That's not even all the companies that are available in the U.S."
He adds, "We're extremely lucky to live in a time when it's so easy and inexpensive to get as much diversification in your portfolio as possible. We should really be taking advantage of that."
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