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Home bias is a term used to describe the inclination of investors to focus their investment activity on securities that are primarily domestic in nature, even if investment in foreign securities appears to be a more lucrative approach. There are several reasons why an investor may exhibit bias of this type, including real or perceived difficulties in buying and selling foreign securities, additional transaction costs associated with executing orders involving foreign investments, and sociological factors that promote the concept of supporting the domestic production of goods and services.
One of the common misperceptions that leads to home bias is the idea that a portfolio carries less risk if all the assets held are domestic. That is not always the case. Depending on the current status of the economy within a given nation, there is the possibility that foreign investments would carry a lower rate of volatility, while still offering the same level of return as a domestic counterpart. Assuming that the foreign investment is not likely to be adversely affected by events currently taking place in the domestic market, the investor may find that the return is even greater with the foreign asset.
Another reason for home bias has to do with legal restrictions and the possibility of increased transaction costs that may be involved with buying and selling foreign securities. In some situations, there may be regulations that limit or even prohibit an investor from acquiring securities issued in another nation. When that is the case, investors can look to investment opportunities in other countries, determine if such restrictions exist, and then compare the possible return with that of similar domestic investments. As to additional transaction charges, there may or may not be more expense involved. Determining up front what those charges would be can help the investor determine if any additional expense is involved, and if the increased transaction cost is offset by the gains anticipated from the acquisition of the asset.
Home bias may also be connected with a sense of national pride. In this scenario, an investor feels compelled to support his or her nation’s economy by purchasing securities issued by businesses that are domestically based, and operate primarily within the home nation. While laudable, this strategy does not necessarily benefit the national economy as effectively as including a few international investments in the portfolio. This is especially true if those foreign interests do business in the home nation, offering employment opportunities as well as selling goods and services.
Many financial professionals recommend diversification when it comes to creating and maintaining an efficient investment portfolio. Part of that process includes consideration of foreign as well as domestic investments, a move that helps to minimize the influence of home bias. Doing so provides a measure of protection from any events that would negatively impact the domestic holdings by offsetting any losses with the gains earned from the foreign investments.
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