Is now the right time for investors to remove home bias from their portfolios?

In today's interconnected global economy and financial markets, the existence of a home bias in portfolios is coming under scrutiny. Understanding it is crucial as it influences investment decisions and the potential returns on those investments.

But what exactly is home bias, and should it be avoided?

Home bias is when investors prefer to invest a greater portion of their portfolio in assets and companies listed on their domestic stock exchange than the region’s representation in a global context warrants. 

For a UK investor, this means a significant portion of an investment portfolio would be in UK-listed companies. Currently, the UK account for about 4% of the global stock market by capitalisation, however, portfolios often hold significantly more in the UK, perhaps 30% or higher and these cannot be sold.   

Historically, there was little need for UK investors to look elsewhere, as British companies dominated global trade and the domestic stock market was a conduit for investment in companies around the world.

Behavioural factors also influence investment decisions. Investors were more likely to back companies they were familiar with as they had greater confidence in what they knew. Globalisation had reversed following World War I and there was increased protectionism across the UK and Europe, leading domestic investors to focus on supporting local growth, jobs and businesses. Whilst this recovered after WWII it took until 1989 for exports as a proportion of GDP to recover to 1914 levels,[1].

Investors in the UK also avoided foreign markets as there were additional risks such as currency fluctuations, political instability and differences in market regulations. As a result, domestic investments appeared safer and more predictable.

The investment landscape has evolved significantly. The UK’s stock market size relative to the rest of the world shrunk over the 20th century as the US and Asia grew. These markets had a greater exposure to new industries and the kind of companies that were likely to drive growth. The performance of the large technology companies has been a significant characteristic of the past 10 years.

Technological advancements also revolutionised the way investors access and manage their portfolios. Online trading platforms, real-time market data and global financial news have become readily available, making it easier for investors to research and invest in foreign markets. The ability to execute trades quickly and efficiently across different time zones has also reduced the barriers to international investment.

As a result, many of the risks associated with international investing have diminished. Global markets have become more interconnected and regulated, reducing the significance of where a company is listed. Additionally, the availability of financial instruments such as exchange-traded funds (ETFs) and mutual funds allows investors to diversify globally and opened new markets, while mitigating individual country risks.

As the world has become more interconnected and investment opportunities increasingly global, home bias has become less prevalent. The necessity for a predominantly domestic portfolio is diminishing, and investors are recognising the benefits of global diversification.

However, it is essential to approach the reduction of home bias thoughtfully. The risks of investing overseas have not completely gone away. Currency risks continue to exist although, for a cost, this can be hedged.

Following Russia’s invasion of Ukraine and growing tensions between it and the US, regulatory and political risks appear to be returning. Investors in any Russian funds will know all too well the risks have risen as their money is now locked in these funds and cannot be sold.

Timing and market conditions play a crucial role in any investment strategy. While it may be beneficial to reduce home bias and embrace global diversification, it is equally important to consider the current state of the domestic market.

The UK market has been unloved for a while. The lack of innovative technology businesses, a bias towards value and unfashionable sectors, such as oil and gas, or banking, has made it unappealing to investors. The growth in ESG has also had an impact given the greater exposure to energy, mining, tobacco and defence sectors in the UK market. The political landscape, including Brexit, has also kept international investors away. These issues led to the UK market sitting on a discount relative to international peers - it currently trades on a p/e ratio of 11 times compared to 21 for the US, 13 for Europe and 14 for Japan.[2]

It is not just the composition of the UK stock exchange that accounts for the lower valuation, as on a like for like basis UK companies frequently trade at a discount to their global peers. For example, the UK energy sector is trading on a forward PE ratio of 8.2 compared to 11.1 for the global energy sector.[2]

As a result, over the past 10 years the UK market has been cheap, but this alone is not enough to attract investors. It is hard to know exactly what the catalyst will be that can trigger a re-rating of the stock market and attract investors back. However, there are signs the UK may be turning a corner, which we have highlighted in our article: ‘Is the UK’s valuation discount a problem?’

Given the low valuations of the UK’s stock markets, the improved outlook for the country’s economy, renewed M&A activity and a new Labour government, now could be a bad time to abandon the home bias.

Our approach at Evelyn Partners is to advocate for a measured and strategic reduction of home bias. Timing and market conditions are important considerations when making large asset allocation decisions. For example, in 2022 the UK’s stock market was the best performing major market as energy stocks outperformed technology peers, providing diversification benefits to portfolios.[1]

We favour gradually increasing exposure to international markets while monitoring domestic market conditions. This balanced approach allows investors to capitalise on global opportunities without prematurely abandoning the potential benefits of the local market, especially at current valuations. This may be something you could consider but it’s important to seek advice to ensure that this is right for your portfolio, your circumstances, and that you understand the risks involved.

We can also take an active approach when investing in the UK market, and by careful stock selection we can avoid companies whose outlook is bleak whilst favouring businesses that offer more attractive growth potential.

Home bias has been a prevalent phenomenon in investment and portfolio construction, driven by historical risks and a lesser need for international diversification. However, technological advancements, reduced risks, and diverging market performance have changed the investment landscape, making global diversification more accessible and attractive. By adopting a measured approach, investors can achieve a well-balanced and resilient portfolio that capitalises on both domestic and international opportunities.

1. A brief history of globalization; weforum.org; June 2019
2. LSEG Datastream/Evelyn Partners