Renowned Fidelity fund manager Peter Lynch popularized the ‘buy what you know’ investing principle in his best seller ‘One Up on Wall Street: How to Use What You Already Know to Make Money in the Market.’ The essence of Lynch’s message, that investors should stick with stocks with which they are familiar, makes intuitive sense. After all, investing in the stocks of companies whose products you use or with a presence in your hometown brings with it a certain level of satisfaction and comfort. However, investors who subscribe to such a theory are at risk of staying too close to home and passing up the benefits that come with a globally diversified investment portfolio.
Home country bias refers to the tendency of investors to be most attracted to investments in their domestic, or home, markets. It is a common pitfall among investors and the relatively small size and concentrated nature of the Canadian stock market means that those in the Great White North are at even greater financial risk than most.
Big Wager
The Canadian stock market makes up only about four per cent of the world’s equity market capitalization and Vanguard estimates that Canadians have approximately 60 per cent of their stock portfolios invested in Canadian equities. This means that the average Canadian is making a big wager on the performance of their home country’s stock market versus those of the rest of the world. And because nearly two-thirds of Canada’s S&P/TSX Composite Index is comprised of financial and resource stocks, Canadians are likewise making a big bet on these cyclically sensitive areas. As a result, over time their portfolios will likely exhibit more volatility and realize smaller returns than one that is more globally diversified. Over the past five years, Vanguard’s Vanguard Total World Stock Index Fund (VTWSX) has bested the return of Canada’s benchmark stock market index by an average of more than two per cent per year.
Over the past several decades, numerous academic studies have attempted to explain this behavioural flaw. Besides investors’ understandable preference for the familiar, their expectations for stock market returns seem to play a role as well. Researchers have found that investors almost invariably expect equity returns in their home markets to be significantly higher than those offered in other countries. We might call this the ‘Lake Wobegon effect,’ whereby all country stock market returns are above average. Of course, we know that all countries can’t offer above average returns; there must be some laggards.
Different corporate governance and investor protection practices among countries may also play a role when it comes to explaining home country bias. Family-controlled firms are quite common across Europe and Asia, much more so than in North America, and there is a perception that minority shareholders are disadvantaged when it comes to investing in the stocks of family-owned companies. Similarly, investor protections are not uniform across borders. As a result, investors may be reluctant to take a more global approach to constructing their portfolios.
Then there is globalization. As economies become more interconnected, domestic companies are deriving more and more of their revenues from abroad. It’s natural, therefore, for investors to think they are getting all the international exposure they need through the stocks of multinational companies in their portfolios. However, studies show that even a multinational company’s performance is highly correlated to that of its home market. To truly realize the benefits of international investing, portfolios need more direct exposure to foreign economies.
Smooth Out
International investing provides risk-reducing benefits that come with diversification. Similar to the old adage about not ‘putting all your eggs in one basket,’ investing globally means not tying your fortunes to a single country. By diversifying across countries, investors can lessen the correlations among stocks in their portfolio, which in turn helps to smooth out their ups and downs.
Being globally diversified also offers the opportunity for better returns. Investors in developed markets, like Canada, can gain exposure to faster-growing emerging and frontier markets and the prospect of higher returns. Similarly, investing outside of one’s home market allows an investor to target countries where valuations are most attractive.
Investing internationally is not without risks. The effects of currency fluctuations, political turmoil, and regulatory uncertainty are just some of the factors that can impact foreign stocks, which helps explain why international funds typically have higher risk and return profiles. However, as part of a larger portfolio, they can offer a disciplined investor better risk-adjusted returns.
What’s an investor to do? Well, a good place to start would be an examination of your portfolio to determine if it does indeed exhibit a home country bias. The typical Canadian investor should think about reducing their allocation to domestic stocks and adding international exposure. The most cost effective way to do that may be through investing in a global mutual fund or ETF. Of course, transaction costs and taxes should be an important consideration. For those reasons, the best course of action for most investors is to consult with a trusted financial advisor.
Of course, diversification isn’t simply a matter of investing proportionately across all asset types and all different regions, it’s about selecting a position that best matches the risk you are willing to take for the return you would ideally like to receive. Remember that there is a world beyond your home market, so try to take advantage of the potential returns it could provide.
David Larrabee (CFA) is director of member and corporate products at CFA Institute and serves as the subject matter expert in portfolio management and equity investments. Previously, he spent two decades in the asset management industry as a portfolio manager and analyst.