The Danger of Investing Too Heavily in U.S. Stocks
You can't blame investors for being skittish about investing abroad, with volatility in Europe and an outright implosion in Chinese stocks. The recent trepidation exacerbates a bias that investors already have in favor of homegrown investments -- a misplaced patriotism that can pummel your portfolio.
Recent research shows that U.S. stocks account for less than half of the global stock market but make up nearly three-fourths of U.S. investors' stock holdings. Investors from other countries are even more provincial. Canadian stocks represent just 4 percent of the world market but 60 percent of Canadians' stock holdings. And get this: Even in beleaguered Greece, where the stock market accounts for less than 1 percent of global market capitalization, the share of domestic stock holdings was recently 82 percent.
Our home bias comes at a price: a dangerous lack of diversification that increases the volatility of returns over time and robs us of opportunities to invest in promising companies that just happen to be based elsewhere. True, in recent years a U.S.-based portfolio has been the best bet, but that's not always the case. For instance, international stocks in developed countries outperformed U.S. stocks from 1983 through 1988, and again from 2002 through 2007.
Our preference for homegrown stocks goes deeper than nationality. A survey by Openfolio, a portfolio-sharing platform, found regional biases as well. For example, West Coast investors are 10 percent more likely than the average investor to hold tech companies, while Southerners are 14 percent more likely to load up on energy stocks.
There are rational explanations for our home-country preference, especially when it comes to international investing. Foreign assets carry an additional currency risk. Trading costs might be higher. Information may be limited. But none of these fully explain what's known as the "home bias puzzle," says Hisham Foad, an economics professor at San Diego State University. Instead, says Foad, blame it on "the predictably irrational behavior of investors."
Overconfident investors. Start with overconfidence. Studies have shown that investors have more faith in their ability to forecast domestic returns, even when it's unwarranted -- for instance, when they're presented with equivalent information about both foreign and domestic holdings.
Loss aversion also plays a role. Investors typically feel pain from losses more acutely than they feel satisfaction from gains. "So you stick with a portfolio that's stable and safe in your own mind, even though empirical evidence says a diversified portfolio would be safer," Foad says.
Finally, toss in some patriotism. Experiments with investors who spoke different languages and hailed from various countries found that they repeatedly chose to invest in companies with which they identified culturally.
Is it so bad to invest in what you know, a philosophy espoused by many investment greats? No, but there's a difference between the investment savvy of an insider (or keen observer) and mere familiarity. The former conveys a real informational advantage; the latter doesn't. And the risk of concentrating your holdings -- nationally and, especially, locally -- are huge, says Scott Yonker, a finance professor at Cornell University who has studied home bias in fund managers. "If your local economy tanks, your portfolio tanks just when you lose your job."
How much in overseas holdings is enough? Research by Vanguard, the giant investment firm, has found that you don't get any additional diversification benefit (chiefly a reduction in volatility) once you top 40 percent in foreign stock holdings. A 20 percent stake, which delivers 85 percent of the benefit, is a reasonable start.