Home Country Bias
The activities of most investors have historically been limited to their home country. This is largely because earlier, there were rules which made the transfer of capital between countries an arduous process. Not only was the process complex, but it also took a lot of time and was riddled with transaction costs. This is the reason that over the years, investors have become accustomed to considering investment options only from their home country.
However, the reality is the investment world has undergone a sea of change in the past few years. Investors now have access to investment options from all across the globe. Also, the process is as inexpensive and hassle-free as local investments. Years of conditioning have created an investor psyche wherein they simply subconsciously omit investment options from other countries. In this article, we will have a look at this phenomenon as well as how it impacts the behavior of investors.
What is Home Country Bias?
Simply put, home country bias is a tendency to place excessive emphasis on the investment options of ones own country. Home country bias is mostly an emotional reaction as it helps investors feel safe if they invest in their own country. Some investors are simply indifferent to the existence of investment options in other countries. However, there are some others who acknowledge these options but then choose not to invest in them because of their behavioral biases. This is the reason that investors all over the world allocate more than two-thirds of their portfolio to investments from their home country. It is strange that this trend encompasses both developed as well as developing nations. Investors in developed nations are willing to forego growth, whereas the ones in developing nations are willing to forego security but prefer to invest in their respective countries.
How Does Home Country Bias Affect Investor Behaviour?
Home country bias might seem innocuous at first. However, the reality is that it can have a devastating impact on the portfolio of many investors. The reasons for the same have been mentioned below:
- Different geographical markets tend to have complementary business cycles. For instance, when the businesses of the United States are facing a recession, businesses in China may be doing brisk business. Hence, when an investor buys stocks from across the globe, they incorporate the diversification into their portfolio. It is common knowledge that diversifying across asset classes adds safety to the portfolio. However, the same investors that diversify across asset classes are hesitant to diversify to different countries because of the home country bias.
- Most developed markets of the world have a stable rate of growth. This is because their years of high growth rates have already passed, and now they are at a higher level and can only grow at a slow pace. This is not the case with emerging economies such as Brazil, India, and China. These countries are rich with resources. However, their economies are not yet up to the mark. Hence, these countries are likely to grow at a faster rate. The reality is that a lot of the growth rate, which can be seen in American asset classes, is because American companies are making investments internationally. The American economy, by itself, has a very slow growth rate.
Home country bias makes the investor myopic. Traditional economics assumes that investors would chase higher returns across national boundaries since they are rational. However, the reality is that many prefer to have sub-optimal gains since they simply overlook the investments available outside the home country.
- Investors with home country bias are also prone to other biases. For instance, they overly emphasize the negative aspects of international investing. Negative effects of regime changes, capital lock-ins, as well as currency rate fluctuations, are overly emphasized. This gives them an illusion that the lower return offered by the home country is actually higher when it is weighted for risks. However, this is not the case. Many of the fears are simply unfounded. For instance, a democratic country is unlikely to implement capital controls overnight. Even if capital controls are eventually implemented, there will be plenty of opportunities for them to exit the market. Some threats, like currency fluctuations, are very real. However, managing that too is within the purview of the investor. They can take derivative positions, which can help shield them from these negative effects.
- If there is too much investable surplus in a country, then the assets in those countries tend to become overvalued. This is because there is too much money chasing fewer assets, whereas, at the same time, assets that provide better cash flow are being ignored. If investors continue to invest in overvalued assets, their portfolios are bound to be negatively affected in the long run.
How Can Home Country Bias Be Avoided?
A lot of investors have been able to overcome the home country bias with knowledge and help from their advisors. The advisors have explained to them that there are financial products that can be used to manage the risks. Financial investors often introduce investors to others who have put their hard-earned money in international markets and hence are reaping higher returns.
The fact of the matter is that the home country bias is an emotional response to investments. It can only be mitigated with a rational response. Since knowledge is the basis for also rational responses, it is the most effective tool in the fight against this bias.
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The article is Written By Prachi Juneja and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.
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