Home bias in investing: what is it and how can you avoid it?
Released On 24th Jun 2024
The old proverb “Don’t put all your eggs in one basket” is thought to have originated sometime around the 17th century in Spain, where it was popularised by the novel Don Quixote. In Spanish, the proverb reads: “Do not put all the eggs in the same basket, to prevent a disaster in case the basket breaks”.
In other words, don’t concentrate all your resources or efforts in one venture because you may suffer significant losses if that venture fails. This is useful advice that you could apply to many areas of life, including your investments.
It’s important to be aware of “home bias” – concentrating all your investments in your home country – as it could increase your exposure to risk. That’s because if all your investments are focused on one market and the economy in that country experiences a downturn, the value of your entire portfolio could fall. Equally, you might be missing out on potential returns from overseas markets.
Fortunately, if you’re aware of home bias and take steps to diversify your portfolio, you may find it easier to manage risk and potentially even increase your investment returns.
The “mere exposure effect” could make you prone to home bias
There are several reasons why you might suffer from home bias, including the “mere exposure effect”. This is a psychological phenomenon that causes us to feel more positively about people, objects or experiences that are familiar to us.
The psychologist Robert Zajonc first identified the mere exposure effect and tested it in numerous ways. For example, when shown pairs of words with the same meaning and asked which had the most positive connotations, participants overwhelmingly chose the words they had viewed more often throughout the experiment.
This demonstrated our natural tendency to stick to the familiar, and this is often why people suffer from home bias. When you’re investing in the UK markets, you’re dealing with companies you recognise and possibly purchase products or services from. Yet, if you invest overseas, you may be more likely to be unfamiliar with the companies, potentially making you feel more comfortable investing in the UK markets. Sticking to investments that you’re familiar with could also make you feel more in control.
That said, the mere exposure effect isn’t the only reason for home bias. You might also be concerned about higher transaction costs in foreign markets, and it could be more difficult to access foreign shares and funds with your investment account.
Home bias could increase the level of risk you adopt when investing
Overexposing yourself to UK markets could increase the level of risk you adopt, and this affects many investors.
An FTAdviser study shows that 25% of the average balanced model portfolio is made up of UK investments. Yet, the UK only accounts for 3% of global GDP and 4% of global equity and bond markets.
The UK markets may also have an issue with “concentration risk”. This is when a small number of companies make up a large proportion of the total market. For example, FTAdviser reports that the 10 largest companies in the UK make up 42% of the total market capitalisation which could mean that if you invest in a UK fund, a large portion of your investments may be concentrated in a handful of companies.
Home bias is an issue because if the UK economy suffers, most companies in the country could experience difficulties and the value of your entire portfolio might fall as a result.
You’re also more vulnerable to social and political factors that could affect your investments. For example, in September 2022, when short-lived prime minister Liz Truss and chancellor Kwasi Kwarteng delivered their mini-budget, the UK markets experienced a significant shock. If you were primarily invested in the UK markets, you may have felt the effects of this event more intensely.
Conversely, if you had diversified and invested in global markets, other investments may have risen in value when your UK shares fell. As a result, the overall value of your portfolio may have remained more stable.
This is why identifying and eliminating home bias in your portfolio may be an effective way to balance risk.
Eliminating home bias could lead to greater investment returns
As well as reducing risk, eliminating home bias could increase your investment returns. This is because you’re investing in markets around the globe and experiencing growth that you might otherwise have missed out on if you only focused on UK markets.
Diversifying your portfolio could also help you balance losses from certain markets with gains from elsewhere and you might see more overall growth.
Figures from FTAdviser demonstrate how much difference eliminating home bias from your portfolio could make.
As shown, if you invested £10,000 in UK markets alone between 2003 and 2022, you would have seen returns of £31,472. Yet, if you’d invested the same amount in global markets for the same period, your investment would have been worth £43,276 – a difference of almost £12,000.
As such, if you are prone to home bias, you may want to review your portfolio and adjust your investments to reduce your exposure to UK markets. Three ways to avoid home bias in investing
1. Invest in overseas markets If most of your investments are in UK markets, you may need to diversify your portfolio. By investing in overseas markets, you may be able to reduce the level of risk you adopt and increase your returns. It could be useful to look at how much each country contributes to the global equities market to ensure that you’re not overexposed to a specific region or country.
2. Check the composition of funds Funds may be a useful way to invest in many different equities and spread your risk. However, they may not be as well-diversified as you think if a handful of large companies make up a significant portion of the market you’re investing in. It may be useful to check the composition of any funds you invest in so you can potentially avoid concentration risk and home bias.
3. Seek professional guidance Working with a professional could be useful, particularly if you’re apprehensive about investing in overseas markets. We can help you create a well-diversified portfolio and prevent home bias. Additionally, we can act as an impartial sounding board and alleviate fears about the potential risks associated with investing in foreign markets.
Get in touch
Get in touch or email us at advice@milstedlangdon.co.uk for more information.
Please note
This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.
The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.
Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.
