Is Home Bias Justified In Your Retirement Portfolio?

Yesterday, we explored whether or not international investing is riskier than domestic investing, our conclusion being that a healthy foreign allocation can both reduce risk and increase returns relative to an all-US portfolio.  But just how much should you have allocated abroad?

Home Bias

Most investors in all countries exhibit a distinct home bias in their investment choices.  Simply put, home bias is when you invest a greater percentage of your portfolio in your home country than a market cap weighted global portfolio, represented by say the Vanguard Global Stock Index Fund, which allocates only about 40% of its portfolio to US stocks.  The vast majority of Americans, needless to see, allocate far more than 40% of their portfolios domestically.

This creates a bit of a contradiction.  After all, if the Efficient Market Hypothesis is correct, the global market-cap-weighted allocation would also be the most efficient one.  And yet, expert after expert recommend American investors allocate only between 20-40% of their portfolios abroad, or significantly less than the EMH would suggest.  There are several reasons for this.

1.  Most People Retire In Their Home Countries- Since most people retire in their native country, it makes sense to keep more of their portfolio at home to guard against unwarranted currency risk.  If the dollar were to rally significantly while in retirement, overseas investments would lose value at the worst possible moment.
2. The Law Of Diminishing Returns - Once you reach a certain international allocation, say 20-30%, the additional diversification benefits of allocating ever larger portions of your portfolio abroad grow smaller and smaller.  While a 40% international allocation does likely have greater diversification benefits than a 20% allocation, the additional benefit of going from 20% to 40% is quite small compared to the benefit of going from 0% to 20%.  For most people, 20-30% is “good enough” even it turns out to be sub-optimal.

 Arguments Against Home Bias

According to Brian Bloch, home bias is an important part of risk aversion and one that leads practically everybody to invest sub-optimally.  To him, home bias is dangerous for investors and should be combated. 

“Home bias and risk aversion are very common reasons for suboptimal portfolio construction, and the essence of the problem is that people think it is rational to avoid foreign investments, because they seem risky”

Some common arguments against home bias include:

1. Don’t Put All Your Eggs In One Basket- Just as you wouldn’t hold the majority of your portfolio in just one stock, neither should you invest the majority of your retirement funds in just one country.  This is a basic principle of diversification.
2. You Are Already Over-exposed To Your Home Country- Because your job and livelihood already depend on your home country’s economic situation, turning around and investing most of your assets there presents a double-whammy when times get tough.  If the economy sours, you stand to lose not only your job, but also your savings at a time when you need them most.

I Take The Middle Ground

My own position is to take the middle ground on this issue.  In my Roth IRA, I allocate roughly 40% of my portfolio abroad and the rest in U.S. stocks, real estate, and bonds.  While this may not be the optimal allocation, I feel it’s close enough for my purposes.  If the U.S. economy tanks, I feel I have enough invested abroad and in bonds to avoid total disaster.  Meanwhile, if the U.S. recovers, I’m poised for strong future returns.  Either way, I should do fine and that is what diversification is all about.