There is a widely observed tendency for investors to allocate more to their own domestic equity market than overseas investors do.
For example, the UK makes up roughly 4% of the MSCI All Country World Index. Most UK investors will, however, have far more than 4% of their equity portfolio in UK equities.
Recent research by Quilter revealed that 64% of UK investors have more than 25% of their portfolio invested in the UK and nearly half had more than 50%. One in 12 (8%) said all their investment was linked to the UK.
While domestic familiarity may make it seem less risky to invest in the FTSE All-Share, this isn’t the case. More than anything, it can compromise diversification. Diversification is often described as the only ‘free-lunch’ in investing, a saying credited to Nobel Prize laureate Harry Markowitz, so the opportunity to do more of it should never be overlooked – and this means taking a global approach.
The long-term case for (some) home bias
But are there any strategic arguments FOR at least some home bias in portfolios?
As it turns out, yes, there are.
The first strategic reason for some home bias is linked to the concept of asset/liability matching: choosing investments that match the characteristics of your future payments.
Most UK retail investors are going to continue spending in pounds in future and their payments will be linked to UK inflation over their lives. It’s true UK listed companies are often global businesses and very diversified overall in terms of their exposures to currencies and countries, but they still have significant UK exposure and so are still the closest match amongst global equities to the future liabilities of UK investors.
The second reason why home bias isn’t necessarily bad in moderation is that domestic familiarity can be turned into an advantage. Ask most international investors how the UK stock market has performed over the last 10 years and they’ll tell you it’s been appalling. And this is true if you look at a market-cap weighted index of UK equities. However, dive deeper and you’ll see the reason for this underperformance is entirely due to large-cap UK equities.
Source: Financial Express, inception of the MSCI ACWI on 29 December 2000 to 30 June 2021
Over the MSCI All Country World Index’s 20 years’ existence, by December 2020 it was up almost 300%. The FTSE 100, covering the biggest 100 companies listed on the London Stock Exchange was up less than half that – just under 140%.
However, if you look at UK small and micro caps (up 361%) and UK mid-caps (up almost 500%), there have been plenty of opportunities to generate healthy returns for the more domestically focused investor.
As an added bonus, these smaller companies tend to be more UK focused – not only is there a strategic rationale for holding them in terms of returns, they will likely have worked better from an asset/liability matching point of view too.
Always moderation
So, there is a solid rationale for at least some home bias and 4% of equity exposure is not the right number for UK investors. That said, neither is 80% or 90% – those promoting the diversification benefits of a global portfolio aren’t wrong in this regard.
Fortunately, there is plenty of room between these two extremes: some, but not too much, home bias is a sensible balance.