Most investors are (or at least should be) familiar with the concept of “home country bias” — the natural tendency to be more familiar and comfortable with public companies in your home country.
Investors everywhere consistently display this trait, which is in direct conflict with the basic principles of international diversification.
A 2014 report by Vanguard found that “Equities not domiciled in the United States accounted for 51 percent of the global equity market as of Dec. 31, 2013.” U.S. equities accounted for the rest. Despite the size of non-U.S. markets, U.S. mutual funds engaged in classic home country bias, holding “only 27 percent of their total equity allocation in non-U.S.-domiciled assets.”
In other words, investors were about 50 percent underweight when it came to equities outside their country. This bias increases the risk and volatility of portfolios, and is a drag on performance.
In the U.S., the impact is partially muted, given the dominant size of U.S. equity capitalization (49 percent) relative to the rest of the world. Nonetheless, the Vanguard study shows that U.S. investors’s holdings of U.S. stocks significantly exceeded the country’s share of the global market.
Now consider the typical domestic portfolio in Canada, which accounts for 4 percent of global equity capitalization. According to a recent survey from the International Monetary Fund, Canadian investors allocate a mere 40 percent of their total equity investments outside Canada. Their local allocation to Canada is about 10 times what it should be. The numbers are similar for the U.K. The considerably smaller size of these markets means that these home country biases create a significant overexposure to home country companies. Radically reduced diversification is the net result.
The local economy affects not only an investor’s portfolio, but their employment and incomes. Hence, there is significant risk tied to the performance of the local economy. The obvious solution is a more global allocation that is closer in relative proportion to global market capitalizations.