HOME COUNTRY BIAS
Asset allocation is the most important driver of long term investment performance. One of the thorniest issues in asset allocation is the home country bias. The home country bias is the tendency of people to invest much more heavily in the financial assets of their own nation rather than spreading their assets throughout the world without regard to where they live. The problem with over-investing in one’s own country or region is that the resulting portfolio will tend to be poorly diversified. Poor diversification usually means much higher risk with little or no added average return.
Modern portfolio theory presents solid arguments that people should allocate their assets across the world’s financial markets in proportion to each country’s financial size. Thus if the UK’s equity markets are 5% of the combined equity markets of all countries, then investors everywhere should allocate 5% of their equity portfolio to equities in the UK.
The U.S. equity markets are estimated to represent about 35%-40% of global equity value, with China and Japan a little less than 10% each. The UK, Canada, France and Germany are all closer to 5% each. The equity markets of a seemingly major industrial nation like Sweden represent only about 1% of global equities.
The home country bias causes most Americans to invest 70%-100% of their equity allocation in U.S. stocks rather than the 35%-40% recommended by portfolio theory. For investors in smaller nations the bias is even more profound. Typical investors in developed nations invest half or more of their wealth in the financial markets of their own country even though ninety-some percent of the world’s investment opportunities are elsewhere.
There are valid reasons for some degree of home country bias such as greater familiarity with the investments and a sense of comfort knowing that your financial performance will tend towards the financial performance of your neighbors. U.S. investors have generally profited well from the home country bias due to the U.S.’s incredibly strong relative economic performance over the last five years.
After five years of stellar U.S. returns relative to non-U.S. returns is it time for international markets to catch up? Should U.S. investors take a closer look at the extent to which they allow the home country bias to concentrate their equity into U.S. financial markets?
In many ways the U.S. markets deserve to be the biggest allocation in most portfolios. The U.S. is #1 in so many ways. Almost all major advances in consumer products over the last 100+ years were invented or popularized in the U.S.: lighting, photography, telephones, automobiles, air conditioning, airplanes, televisions, and computers. The U.S. has had the strongest military power for decades. U.S. brand names are known and purchased throughout the world and U.S. entertainment (films, sports, television and music) dominate the world’s markets. The U.S. enjoys the most advanced healthcare techniques for critical illnesses and is on the forefront of medical advances. The U.S. is home to the majority of the top universities in the world in most disciplines. And let’s not forget the total medal count at the Olympics!
But what about the future? I believe that America will continue to thrive economically as long as it maintains the foundations that supported the tremendous advances of the past: a spirit of daring entrepreneurship, a strong rule of law, institutions that protect private property rights, and strong support for the rights of individuals and the importance of liberty.
The warning signs that the U.S.’s great leadership is waning will be when America abandons the institutions on which the nation has prospered. One sign will be when Americans lose respect for the successful business and professional people who created the nation’s prosperity through their innovation and leadership. Another sign will be when a majority of Americans are driven by greed to vote to take money from those who earned it and spend it on transfer payments and social programs that reward the lazy and incompetent. Another sign will be when income and wealth equality are viewed as important goals rather than as devastating disincentives. The decline will be near when the nation views community organizers in higher esteem than its entrepreneurs. The final warning sign will be when the wealth created by the nation’s great innovators is viewed as being earned by and belonging to the political elite and their supporters.
After five years of extremely high U.S. financial market returns and, to the extent that one views the political environment in the U.S. as turning hostile towards business, it may be time for U.S. investors to take a serious look at the extent to which their asset allocations are exhibiting a home country bias. Even if U.S. equity returns are able to match the returns of the rest of the world over the next five years, a well-diversified global portfolio will tend to have lower volatility than a portfolio with a strong home-country bias. Major changes to portfolio allocations should not be made quickly and frequently. But U.S. investors with over 80% of their equity in U.S. equities and with almost all of their fixed income wealth denominated in U.S. dollars are taking a poorly diversified bet, and a bet that might turn out quite badly in the not-to-distant future.