The reasons for sticking to local stocks are fewer by the day.
A version of this article appeared in the May 2017 issue of Morningstar ETFInvestor. Download a complimentary copy of ETFInvestor here.
If diversification is the only free lunch in investing, investors are leaving a lot on the lunch table. Diversification is measured across a number of dimensions: individual stocks, industries, sectors, and so on. Most investors' portfolios are fairly well spread along these lines. However, when it comes to investing overseas, many decide to ditch diversification at the border.
"Home bias" is the term used to describe investors' tendency to tilt their portfolios in favor of domestic stocks (bonds, too, but I'm going to focus on stocks). Here, I'll discuss how home bias is measured, the factors that underpin this phenomenon, and why it's probably a good idea to expand your horizons a bit--especially given current valuations.
A Baseline for Bias
There are a number of measures of home bias that have been derived by academics through the years. But, for the sake of simplicity, I believe it's easiest to measure your home bias by comparing your current allocation to international equities with the portion of the market capitalization of global stock markets made up of stocks domiciled outside of the United States. Exhibit 1 provides a snapshot of the makeup of the global market as of the end of March. As you can see, U.S. stocks make up about 53% of the world's public equity market cap, with foreign stocks accounting for the remaining 47%. So, for example, using a market-cap-weighted portfolio of global stocks as our arbiter, any U.S. investor's stock portfolio that has an allocation of more than 53% to U.S. stocks is showing a home bias. Exhibit 2 shows the magnitude of home bias among investors in the U.S., United Kingdom, and Australia and how it has diminished (somewhat) over the years.
The Basis of Bias
There are a number of reasons investors might have overweightings in domestic stocks. Some are tangible, others intangible.
There are many concrete, measurable explanations for why investors tend to favor local stocks.