RSS FeedBy M. Isi Eromosele
U. S. investors typically allocate only a small share of their portfolio to foreign assets. This pattern of investment strategy, known as “home bias” is puzzling because it causes investors to miss great opportunities to diversify risk. However, recent trends suggest that home bias might actually be declining. During the past decade, U.S. investor holdings of foreign financial assets, such as stocks and bonds, have made remarkable gain.
The change in U.S. foreign investment position has taken place along three aspects; the magnitude of the stock of foreign assets held in U.S. portfolios, the composition of investments abroad and the geographical allocation of foreign investment. The change in investment behavior is due partly to a growing pool of money available to fund foreign investment.
The growing willingness to invest abroad has enabled U.S. investors to diversify their portfolios, thereby reducing the volatility of investment returns. In discussing the gains that diversification might achieve, some essential characteristics of investor preferences should be noted. Investors usually prefer high returns, yet they dislike the volatility that often accompanies high returns. Foreign stocks are typically influenced by factors other than those that affect the U.S. equity markets. Foreign stocks typically depend far less on the variances that influence the U.S. business cycle.
The increased willingness of U.S. investors to purchase foreign stocks is a welcome development. U.S. investor increase of their holdings in foreign industrial countries’ stock can potentially lead to higher average returns that would also be less volatile. However, though it has declined, the bias against investing in foreign equity markets persists across different foreign markets. The reason for this behavior might lie in the evolution of bias toward investments in certain countries or regions of the world.
By definition, bias is zero when the share of a given regional stock market in the U.S. portfolio is equal to its share or weight in the world market capitalization. The closer this indicator is to one, the larger the bias will be. In the U.S. stock market, the formula produces a negative number of U.S. stocks or a negative bias. As such, U. S. investment still displays home bias because it favors domestic stocks. It should be noted that while bias in U. S. investment has declined in some markets, it has not in others.
There are three factors that have influenced U.S. investors’ inclination to invest in some foreign markets, but not in others. The first factor is a broad category of institutional elements, ranging from regulatory issues to property rights. The second factor is the level of returns provided by foreign markets. The third factor is the opportunity of risk diversification, or the extent to which certain foreign stocks can be seen as a good hedge against adverse fluctuations in the U.S. business cycle. Diversifying risks has played a major role in changing the geographical pattern of U.S. investments in foreign stocks.
Overall, the bias toward foreign market has declined. But, in some cases, bias has remained stable (Latin America) or become even stronger (Eastern Europe). The foreign markets that offer better opportunities for risk diversification are in three economic regions of the world: major industrial countries (G7), other advanced economies and emerging Asian markets.
M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance
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