Home bias is when investors prefer domestic securities over foreign ones, despite foreign investments being more profitable. This bias can be due to difficulties in buying foreign securities, higher transaction costs, legal restrictions, and national pride. However, diversifying a portfolio with foreign investments can protect against losses in the domestic market.
Home bias is a term used to describe the inclination of investors to focus their investment activity on securities that are primarily domestic in nature, even though investing in foreign securities appears to be a more profitable approach. There are several reasons why an investor may exhibit such biases, including actual or perceived difficulties in buying and selling foreign securities, additional transaction costs associated with executing orders involving foreign investments, and sociological factors that promote concept of supporting domestic production of goods and services.
One of the common misperceptions that leads to home bias is the idea that a portfolio carries less risk if all of the assets held are domestic. This isn’t always the case. Depending on the current state of the economy within a given nation, there is a possibility that foreign investment will carry a lower volatility rate while still offering the same level of return as a domestic counterpart. Assuming that foreign investment is unlikely to be adversely affected by events currently unfolding in the domestic market, the investor may find that the return is even greater with foreign activity.
Another reason for home bias has to do with legal restrictions and the possibility of higher transaction costs that can be involved with buying and selling foreign securities. In some situations, there may be regulations that restrict or even prohibit an investor from purchasing securities issued in another country. If so, investors can seek out investment opportunities in other countries, determine whether such restrictions exist, and then compare the possible return to that of similar domestic investments. As for the additional transaction fees, there may or may not be any major fees. Determining in advance what those charges would be can help the investor determine whether additional expenses are involved and whether the increased cost of the transaction is offset by the expected earnings from acquiring the asset.
Family prejudice can also be linked to a sense of national pride. In this scenario, an investor feels obligated to support his nation’s economy by purchasing securities issued by companies that are nationally based and operate primarily within the home nation. While commendable, this strategy is not necessarily beneficial to the national economy as effectively as including some international investments in the portfolio. This is especially true if those foreign interests do business in the home nation, providing employment opportunities and selling goods and services.
Many financial professionals recommend diversification when it comes to building and maintaining an effective investment portfolio. Part of this process includes consideration of foreign and domestic investment, a move that helps minimize the influence of domestic bias. This provides a measure of protection from any events that would negatively impact domestic holdings by offsetting any losses against gains earned from foreign investments.
Smart Asset.
Protect your devices with Threat Protection by NordVPN
