by Prof. Manfred Frühwirth
There is no place like home, so the saying goes. But that is not always true, and this also applies to financial markets, as is illustrated by the home bias, a phenomenon according to which investors prefer to make investments in their home countries.
In 2014, US investors invested 79.1% in the US stock market, although US stocks accounted for “only” 50.9% of the world stock market. Canadians kept 59% of their investments at home, while Canada had a world-market share of just 3.4%. And as far as Austrian investors are concerned, a 2003 study found that they invested some 39% in domestic stocks—compared to a 0.17% share in the global stock market.
This is problematic in so far as Bruno Solnik's International Capital Asset Pricing Model (CAPM) demonstrated, as early as 1974, that, ideally, the structure of an investor's stock portfolio is equal to that of the world stock market. In other words, the proportion of investments that investors make in their domestic stock markets should correspond to the share that the domestic stocks have in the world stock market. Bruno Solnik did not take market frictions into account; nevertheless, his rule is a good benchmark to illustrate the home bias.
It is often claimed that the fees entailed by investments in foreign stock markets are too high or that making such investments is too complicated. These arguments are no longer tenable, though: As the world has become more and more globalized, capital markets have been integrated, and transaction costs for international investments have significantly been reduced.
The home bias exists for the following reasons: People do not like uncertainty and complexity, and tend to put their money where they are, supposedly, able to assess the overall situation and the risk. The domestic market inspires greater confidence. Investors know the companies, the language and the culture. Foreign financial markets, by contrast, are rather perceived as being complex, hard to navigate and uncertain. Moreover, studies have shown that when it comes to the question of future development, people feel more optimistic about the domestic market than they do about foreign markets.
As is illustrated by Bruno Solnik's model, you should definitely diversify internationally when it comes to making investments. The capital markets of countries correlate only weakly with one another. Research shows that diversifying investments internationally yields a higher return (at the same level of risk). In other words: Through international diversification, you can significantly increase the sharpe ratio (the earned risk premium per unit of risk).
Make an international asset allocation and gain clarity about how much you invest at home and abroad, respectively. Bruno Solnik's model is a good yardstick to use in this context: If Austrian stocks have a 0.2% share in the world stock market, you should invest only about 0.2% of your stock portfolio in Austrian stocks and diversify the rest internationally. Again, you can, for instance, use Bruno Solnik's model, and weight the countries according to their world market capitalization shares. Some international ETFs do this for you. One good example is the SPDR MSCI ACWI IMI ETF (securities identification number: IE00B3YLTY66), which tracks an index of over 8,800 companies worldwide. The iShares MSCI ACWI ETF (IE00B6R52259) and the currency-hedged iShares MSCI World EUR Hedged ETF (IE00B441G979) are other market-capitalization-weighted ETFs. The latter offers the advantage of currency hedging but has the disadvantage that it does not include stocks from emerging economies.
You do not necessarily have to use Bruno Solnik's model when it comes to internationally diversifying your investments. Another strategy is to weight country funds according to the shares of the respective GDPs in the total global gross domestic product. If you consider both of these suggestions too laborious, you can stick to the good old 1/N rule of thumb, under which you equally weight all the countries you want to invest in.
This article was published in the Austrian business magazine GEWINN. Read the original article
here (in German).