The topic has been researched by a number of well-respected academics and investment professionals, and is a factor that many investors overlook. The term putting “all your eggs in one basket” comes to mind. Investors could significantly reduce their risk exposure if they held a portion of their asset portfolio in foreign stocks.
In addition to this, there is the risk that the domestic market underperforms resulting in below par investment performance. Academics have proposed a number of reasons for this bias to become prevalent, but no matter the origins, failure to diversify abroad places the investment portfolio at risk of heavy drawdowns through limited diversification from local market risks.
Home bias and international diversification
Studies have shown that, over the long term, equity markets tend to outperform many other asset classes and, although the investor must tolerate an elevated level of risk, equities remain a core component of both private and institutional investor portfolios.
The investment decision with regards to share choice is an entire industry within itself. However, one aspect which most astute investors will be aware of is diversification. The major benefit of diversification is that it reduces portfolio risk by decreasing exposure to any single element. In addition to this, research has shown that there are significant added benefits to international diversification.
Failure to diversify across international markets is often referred to as “home” or “domestic” bias. Many investors fall victim to this bias because of the ease of access to information regarding local firms, their own inexperience and anxiety with regards to offshore investment and the potential tax or cost implications which may arise. Many of these biases and concerns may be unwarranted, and they conceal the reality that investing solely within domestic equities presents a significant opportunity cost.
The chart below depicts the world not according to land mass, but by the size of each country’s stock market relative to the world’s total market value. While the US is by far the largest market, it is interesting to note the wide dispersion following that. China, Japan, Germany, France and the UK, which make up the next five biggest economies (as measured by GDP and according to the World Bank), make up a combined share of just 22% of market caps.
The implications here are significant as the domestic investor in developed financial centres such as South Africa, or even Spain and India, are exposed to just a fraction of the global equity market, heightening local market risk, while limiting exposure to offshore gains.
Figure 1: World market capitalisation (£23.1 trillion as at 31 December 2012)
With this knowledge in hand, the prudent investor may make an effort to diversify across international markets. However, the question remains as to where exactly they should place their money. The chart below shows annual equity returns of developed markets. Interestingly, the US outperforms its peers on just one occasion. Thus market size is perhaps not the best indicator of where to invest.
Figure 2: Equity returns of developed markets (annual return, GBP %)
It is clear from the data that there are significant benefits to investing outside of your domestic market, but as it is near impossible to determine which market will deliver optimal returns, it makes sense to diversify across as many countries as possible. This will expose your investment to the largest and most developed capital markets, while elevating your risk-adjusted return.
This is easier said than done, and opening your portfolio to international markets may seem like a daunting prospect. However, this need not be the case. Sable International's investment portfolios are, by construction, heavily diversified across global financial markets. Furthermore, given the nature of the funds in which they have been invested, costs have been kept to a minimum. As a result, by moving your portfolio over to us, you will enjoy all the benefits of an internationally diversified portfolio at a cost likely to be lower than a domestically invested fund.
 Jeske, K. (2001) Equity Home Bias; Coval, J. & Moskowitz, T. (2002) Home Bias at Home Local Equity Preference in Domestic Portfolios; Steiman, B. (2008) When Home Bias and Hot Bias Collide
 See: French, Kenneth; Poterba, James (1991). "Investor Diversification and International Equity Markets". American Economic Review
Tesar, Linda; Werner, Ingrid (1995). "Home Bias and High Turnover". Journal of International Money and Finance
Coval, J. D.; Moskowitz, T. J. (1999). "Home Bias at Home: Local Equity Preference in Domestic Portfolios". Journal of Finance