Does your financial portfolio suffer from home bias?

Home bias, or the preference of investors to allocate heavily to their home financial markets rather than diversify globally, is a phenomenon demonstrated by investors across most markets.

The Gulf Cooperation Council is no exception to the home bias preference. The intuitive response to buy locally has outweighed the benefits of diversification greatly. However, why is this bias still pervasive in an increasingly globalized market with easy access to various financial instruments across asset classes?

A recent Federal Reserve Bank of Atlanta study measured the extent of home bias by looking at actual investor allocation to domestic equities relative to that market’s weight in global markets from a market capitalization perspective.

For example, US equities constituted about 50 percent of global market capitalization at the time of the study. Still, data showed US investors allocated about 90 percent of their equity investments to US markets. This gap was even wider for other major markets.

The bias for investors to invest primarily in domestic financial assets is significant.

Various studies have attempted to understand why investors demonstrate this preference. One possibility is the cost of investing globally, which can be prohibitively high in some markets. However, for many major markets, it is often not high enough to outweigh the benefits in terms of investment returns and volatility reduction.

A second possibility is information asymmetry. Local investments come with the appeal of adding exposure to what the investor knows. While having a sufficient understanding of one’s investments is a fair ask, the same Fed study noted that the implicit information cost of missing the benefits of global diversification appeared to be very high.

Third is the avoidance of taking on excessive currency risk. While this may be less of a challenge in equity markets, where foreign exchange volatility tends to be a smaller portion of returns over time, this can pose a bigger share of returns in asset classes such as bonds.

Bias among GCC investors

Several studies have examined home bias among GCC investors in recent years, and results show that they exhibit a strong home bias for local and regional markets.

The level of home bias is variable in the region, with one study concluding that professional investors in Qatar had relatively smaller home biases than fund investors in neighboring markets. While many factors impact the degree of home bias, a key influence is the range of home market opportunities available at a given time.

When it comes to individual expatriate investors, though, most studies show they hold a home bias, but largely to their home markets. This inclination holds across the region, not just in Qatar. And unsurprisingly, one of the most likely drivers of home bias is familiarity with one’s home market, which can lead to suboptimal portfolios because investors usually benefit from diversifying globally as far as possible across regions, asset classes and currencies.

Is home bias a problem?

An excessive home bias can hurt one’s financial health due to a lack of diversification in mitigating the potential impact of regional volatility.

For example, energy market players who limit their investments to a domestic equity market weighing densely on the energy sector would be doubling the concentration risk in one industry.

Even a normal cyclical downturn in the industry would pose a risk to non-diversified investors as their personal earnings and investment portfolio decline simultaneously.

We can see this impact in terms of currency exposure. Over the past two years, many major currencies, including those of emerging markets, weakened in the face of the mighty US dollars. While this could partially reverse should the dollar weaken in 2023, as expected, even a tiny allocation beyond local market assets would have helped smoothen one’s investment performance.

Home bias, by its nature, means disproportionately larger exposure to one’s home currency. This bias supports mitigating foreign exchange risk but does not eliminate it completely.

While perfectly integrated international financial markets remain a dream and lower transaction and information costs will undoubtedly help home bias to decline more steadily, investors must make a conscious decision to diversify globally as the benefits allow for greater portfolio diversification and more efficient allocation of capital resources.

• Manpreet Gill is chief investment officer for Africa, the Middle East and Europe at Standard Chartered Bank’s Wealth Management unit.