Summary: Home-Bias In Investing
Home-bias investing is the practice of investing a disproportionate amount of your portfolio in domestic companies, often at the expense of diversification, and capital efficiency. Investors are often more comfortable in allocating capital to companies they are familiar with as they seem more tangible and thus safer.
Why is it important to invest internationally?
1.36%. That is Canada’s share of global GDP. Due to the fact in the grand scheme of things we are not a “big fish”, investors can often find more productive homes for their capital by looking outside our borders. Canadian companies certainly have growth potential, however, due to our smaller population, and lack of diversification into industries such as technology and healthcare, Canadians often find themselves at a disadvantage when compared with their investor peers south of the border.
An intuitive way to evaluate investment opportunities is by capital productivity, or the expected return on invested capital (ROIC). Naturally we would prefer our invested capital to produce the greatest outcome all else being equal, thus the larger reward for investors. Research has historically shown us that different capital market regimes in different geographic regions influence an investor’s ROIC through societal norms and pressures. Some regions exert greater pressure on corporate managers to produce more favourable results for employees, communities, or shareholders. As a potential investor, it would be most efficient to seek out regions such as the U.S. which have a greater bias towards rewarding shareholders relative to the other stakeholders.
What are the risks of not diversifying?
A shock to a key Canadian sector may prove more harmful to a portfolio which isn’t globally diversified – that much is easily apparent. Another risk which may not be so obvious in the case of an economic shock is the effects on a Canadian’s employment, income, and even property value which may also feel negative reverberations. This risk is not always diversified away simply by investing outside of one’s field of employment. Our country’s economy is all interconnected, a shock in the energy industry for example may hurt all kinds of companies which provide goods and services to energy companies and the staff of energy companies.
Professional investors and individual investors often think about risk quite differently. A professional investor can typically ride out short term ups and downs. The risk in managing a pension fund, mutual fund, or otherwise pooled money is failing to achieve a target long term rate of return. This is in contrast with how individual investors often consider risk to be a short-term loss of capital. This can be explained for many reasons, differing time frames, understanding of financial market concepts, etc. however by not maintaining a geographic and sector diverse portfolio, the long-term rate of return is at greater risk, often not at the expense of increasing the potential for short-term loss of capital.
Breaking down the numbers
If you were to invest only in Canada, in proportion with the S&P/TSX Index your portfolio make-up would be almost 60% allocated to our countries three main sectors: Financials (30%), Materials (14%), and Energy (14%).
Comparatively, the MSCI World Index has a 3% Energy, 4% Materials, and 12% Financials allocation with Information Technology and Healthcare being the top 2 weightings in the MSCI World Index. This tells us that the companies which attract the most investment in Canada are not in the most sought-after sectors to invest in globally, thus those companies may have a harder time in a more globalized world.
The performance gap of return on invested capital is clear when we zoom out over an extended period of time. $10,000 invested in the MSCI World Index on December 31st, 1976 would be worth $881,804 after adjusting for the effects of foreign exchange whereas $10,000 invested in the Canadian S&P/TSX would now be worth $563,442.
Conclusion: Home-Bias In Investing
Ultimately, investing is something that can often be refined over time as the famous quote goes “you don’t know what you don’t know”. Certainly, there is no single investor who knows it all so to a certain degree we sometimes must accept there will be inefficiencies in our plans. And where suitable it may be prudent to seek out a professional second opinion.
As a counterpoint to all the evidence provided above, I always say that the worst investment someone could make is one that makes them uncomfortable. Inevitably discomfort will leave to inopportune timing, emotional decisions, and missed opportunities. It is important that consequential decisions such as investing be well thought out, however we all must also realize we are human and imperfect.