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.
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.
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.
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.
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.