Familiarity bias examples: equity home and local bias

Despite information from a wider variety of sources being more readily available than ever before, familiarity bias remains an issue. Investors stick with what they know.

Gaining exposure to stocks listed outside our own countries and continents has never been easier. Nevertheless, the evidence points to a continuing preference for investors to plump for home-domiciled companies.

Familiarity bias has a lot to do with this continuing trend. Human brains are hardwired to favour what’s closest to home.

Missing out

In the US, investors put around 50% of their equities portfolio in US-listed stocks, despite such companies accounting for 30% of global stock market capitalisation.

Although UK investors allocate around 25% of their money to home-domiciled companies, UK-listed stocks make up just 7% of world capitalisation.

Japanese investors put a whopping 80% of their funds in Japan-listed companies, despite such names accounting for only 9% of world capitalisation.

These figures indicate that many investors are missing out on opportunities simply because they are biased to the stocks listed in their home countries.

Top ten

At present, the top ten public companies in the world by market cap are all US listed, except for a couple of Chinese internet companies (Alibaba and Tencent). Four out of the top five are US technology names – Apple, Alphabet, Microsoft and Amazon.

This all means that a UK investor holding a portfolio comprised only of UK-listed stocks would be severely lacking exposure to the world’s biggest companies.

Familiarity bias

In psychology, familiarity bias (heuristics) refers to the phenomenon where people opt for the more familiar options, even though these often result in less favourable outcomes than available alternatives.

Similarly, in investment there is “equity home bias”, which describes the tendency of investors to favour domestic stocks versus overseas equities.

Home bias theory was documented by academics Kenneth French and James Poterba in their 1991 paper Investor Diversification and International Equity Markets.

The paper found that investors in major nations irrationally expected returns from their domestic equity market to be several hundred basis points higher than returns from abroad.

Geography of investment

A later paper, published in 1999 by academics Joshua Coval and Tobias Moskowitz, found that fund managers favoured investing in companies within a closer range of their own headquarters, even within their home countries. This is taking familiarity bias and equity home bias to the extreme.

Surprisingly though, the paper also found the strategy was resulting in higher returns for portfolios. According to the study, the average fund manager generated an additional return of 2.67% versus non-local holdings.

“Local holdings” were defined as companies located just 100 kilometres from the investment companies’ own headquarters! “Our findings suggest that fund managers are exploiting informational advantages in their selections of nearby stocks,” said the paper.

Investment managers could understand those companies based closer to home a lot better than those further afield.

Changed world

The world today is vastly different to that of 1999, let alone 1991. Technological innovation, especially the growth of digitalisation and the internet, means it’s a lot easier to research as well as invest in overseas equities.

A far greater propensity of information at the touch of a button must mean investors feel more emboldened to look outside their own backyard for investment ideas.

While there is still plenty of scope for investors to increase their allocations to overseas equities, there has indeed been some progress over the years.

Staggering as it may seem, in 1989 US investors had some 94% of their portfolio in domestic equities compared to around 50% today. In those days, UK investors had 82% of their equities holdings in UK-listed stocks versus the current 25%.

Japanese investors, meanwhile, then had around 98% invested in home-domiciled names compared with the 80% still allocated in this way today.

Increasing interconnectedness

Considering the increasing interconnectedness of the world economy, as a function of globalisation and rapid dissemination of new technologies, the level of correlation between international stock markets appears to have increased over the years.

In 1970, the rolling 36-month correlation co-efficient of UK equities versus international stocks was 0.40. The same co-efficient had risen to over 0.80 by the beginning of this decade. This means that the relationship between UK and international stocks is about twice as strong as it used to be.

Today, a sharp sell-off in overseas stocks is more than likely to affect confidence in London-listed equities.

Part of the reason for this lies in the increasing internationalisation of stock market flows in recent years, and the higher allocations investors have been making towards non-domestic equities.

Chinese internet name Alibaba is one of the biggest companies on earth.

Currency risk

Currency risk is still a major consideration for those investing in equities outside their own borders. While currencies tend to stabilise over the longer-term, near-term currency fluctuations can be immense.

If your home currency decreases against global counterparts then your overseas investment returns receive a short-term boost in home currency terms. The opposite is the case when your home currency appreciates versus a foreign counterpart.

For instance, since the Brexit vote, sterling has depreciated by around 13% and 17% against the dollar and the euro respectively. This has benefited returns for UK investors in dollar and euro denominated investments by the same amount.

At times, currency fluctuations can outweigh the returns from foreign investments in local terms.

Investors can choose to mitigate the risk posed by currency movements by easily implementing currency hedges that will neutralise their impact on portfolio returns. Alternatively, we can take a long-term view, and wait for currencies to revert to historical averages.

International diversification benefits

The best investment opportunities are not necessarily going to be on your home turf. Discovering the Apple or Alphabet of tomorrow could easily mean having to cast the investment net into parts of Asia or even more widely across emerging markets.

Investing in stocks listed overseas can raise the potential return of portfolios, as well as reducing risk. The latter has historically been the case because overseas stock markets have performed differently to investors’ home markets.

For example, the average fund invested in UK equities has risen by just under 70% over the past five years versus a return of nearly 120% for the average fund invested in North American equities (both in sterling terms).

Fighting familiarity bias

Investors need to ask themselves if they are adequately evaluating all reasonable investment opportunities for their equities portfolios.

Being overly biased towards stocks because they are more familiar and closer to home means investors could be missing out on the best opportunities and severely limiting their investment returns.

In an increasingly interconnected world, the mega stocks of tomorrow are probably more likely to be from China than they are from the UK. Any form of familiarity bias will hold an investor back.

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