Risk is complicated. What looks risky in theory may be less risky in reality—and vice versa. Here we highlight domestic bias risk and dig deeper into how investors may be overlooking ways to optimize their portfolios for proper risk management through international investment.
Domestic bias: The case of home base
Many investors and financial professionals tout the strength of global diversification to reduce the risk of being concentrated in one region. Most would agree that a broader range of assets can help weather market hiccups. But a closer look at data shows that investors may not be listening to their own advice. Perhaps this is out of a fear of the unknown.
Domestic bias is the inclination of investors to target assets in their own country, and it’s by no means a new concept. In 2005, before the onset of the global financial crisis and before China rose through the global ranks to become the world’s second-largest economy by global domestic product (GDP), investors were subscribed to domestic tendencies. Academic researchers Kalok Chan, Vincentiu Covrig and Lilian Ng found that in all of the 26 countries they studied, allocations to domestic markets had far greater shares than the world market capitalization weight of the country. Greece had the highest percentage of mutual investment holdings in the domestic market at 93.5%. To put that in perspective, the country’s world market capitalization weight is 0.46%. The U.S. had the second-highest percentage of domestic investments, though the spread relative to world market capitalization is much smaller at 85.7% to 46.9%. They published these findings in the “Journal of Finance” in June 2005.
The researchers also found that investors tended to underweight markets that were foreign to them, supporting the argument that an investor’s own geographical location tends to have a significant influence on how they structure their portfolios.
Greater stability in numbers?
Over time, as technology facilitates global communication, as businesses expand overseas, one would assume that investors become more comfortable with investing beyond their front yard. Let’s fast forward to 2009. The global financial crisis has reshaped financial markets. Ukraine, Argentina and Hungary were the three countries most affected during September 2008 to May 2009, according to the Carnegie Endowment for International Peace. Although the U.S. was at the core of the crisis, it was the third least impacted country globally. China and Japan were the two countries least impacted. Even so, investors in these countries would have still experienced ripples in their portfolios, large or small.
A portfolio diversified across a range of countries may have helped investors manage the risk of being caught in one or a group of countries that were adversely affected by the crisis. But investors hadn’t adopted the change, it seemed. After running 10,000 simulations, researchers Wioletta Dziuda and Jordi Mondria found that 73% of investments in mutual funds went to domestic markets. Aggregate domestic bias in the U.S. was 85%. They published their findings in Kellogg Insight in September 2009.
How has that evolved today? The markets are not what they used to be, and investors are likely well aware. But the core trend has not really changed. A 2017 Bruegel study by Zsolt Darvas and Dirk Schoenmaker on the European Union (EU) investigating home bias found that investors continue to rely on domestic assets.
Investment universe growth
In reality, many goods and brands that people use today are created outside their own country. But this level of comfort with foreign assets is not as pervasive among financial investment. Are there other factors that have prevented investors from increasing exposure to international assets? There could be.
The availability of domestically-issued securities tends to influence home bias, according to the Bruegel report. In other words, countries that have a larger selection of domestic stocks tend to diversify less. At one point, this did make sense. There simply weren’t a lot of options. But today, that has significantly changed. Take the emerging markets universe as an example. The MSCI Emerging Markets (EM) Index opened in 1988 and consisted of eight countries; it now comprises 25 countries. The MSCI EM Small Cap Index was introduced in 2007 and targets companies in the top 99% of the investable universe below the MSCI Standard (Large and Mid-Cap) Indices, citing the rise in the number of available securities for investors to choose from.
In comparison, the number of U.S. publicly-traded companies has declined over time. There were more than 7,000 public U.S. companies in 1996. There were fewer than 3,800 in 2016, according to the Center for Research in Security Prices (CRSP). This was likely influenced by a number of factors, including a drop in initial public offerings (IPO). However, the report pointed to one element a domestic company has that a foreign one does not: the ability to conduct business transactions in one currency. The report noted that the elimination of currency risk could boost an investor’s likelihood to make cross-country investments, especially within debt securities.
Partnering with local experts
That said, it seems unlikely that currency risk could ever be altogether eliminated unless the entire world were to operate on one currency. How can investors minimize currency risk so they can boost their exposure to international assets as a way to diversify and manage overall portfolio risk?
There’s no one right answer. Let’s revisit fear of the unknown. Do people stick to what they know because it’s more certain? Generally, that’s likely true. But investors are supposed to give more analytical thought to their decisions. Why do they also show the same behavior when making investment decisions?
According to the Kellogg Insight study, one major reason for domestic bias is the availability of domestic information. Domestic information is readily available on local news outlets. Investors can talk to their friends and neighbors to ask how they think the domestic economy is faring. They can observe what others around them are buying or doing. In essence, it’s “cheap” information, as the survey called it.
But is cheap and easily accessible information a practical reason to refrain from going abroad? It may be for some investors. For long-term investors with larger assets or the right risk tolerance, cheap and easily accessible information may mean missed opportunities. Investment managers with global resources also have access to regional information and intel, which can help investors achieve their goals by sharing local expertise. With today’s ability to share information and communicate globally at the click of a button, investors should consider partnering with eyes and ears in different parts of the world.
Diversification does not ensure a profit or protect against a loss in a declining market.
Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.