Everybody loves the comforts of home, but investors who become too anchored to familiar territory can end up with a very narrow view of the world.

Home bias, the tendency of investors to allocate a disproportionate amount of their funds to their domestic market, is a well-documented phenomenon.

As at 31 December 2016, superannuation funds regulated by the Australian Prudential Regulation Authority had nearly 50% of their total equity exposure in local shares. For self-managed super funds, the average home allocation was 72%.

There can be rational reasons for home bias. Australian investors, for instance, have the advantage of dividend imputation. This is where firms that have already paid income tax on profits attach tax credits in distributions to shareholders.

A second understandable reason they might tilt to their home market is familiarity with the companies they are investing in. Companies like Westpac, ANZ, Qantas and Air New Zealand are household names and are frequently in the news.

A third justification might be that a home bias satisfies an individual investor’s particular goals or risk appetite. These are all issues for an advisor to consider.

But a large home bias also can have undesirable consequences. Those consequences relate to the risks of a portfolio ending up with very concentrated exposure to individual countries, companies, and sectors.

DIVIDING UP THE WORLD

This is particularly the case where your home market is relatively small in a global sense or where it is dominated by one or two sectors.

Chart 1 shows the natural weights of some of the countries in the MSCI All Country World index, a popular benchmark for the global share market. You can see the US is by far the biggest market, with a weight of more than 53% as at 31 January 2017.

Japan is a distant second with a weight just above 8%, then the UK, Canada, France and Germany, China and Switzerland. Australia is ninth with a weight of 2.4%, while New Zealand is in 36th place with a weight of just 0.1%, too small to see on the chart.

Now, what happens when we bias our portfolio to the home market? Chart 2 shows the country representation in an equity portfolio with a home bias of 60% to Australia.

As a result of this tilt, we have to scale down representation of other major markets. For instance, the US exposure is lowered from 53% to 22% and emerging markets from 11% to just 4%. Put another way, the weight of all countries, apart from Australia and the US, in this portfolio is just 18%.

So you can see that this degree of home bias represents a pronounced deviation from the global market portfolio and leaves you taking unnecessarily big bets. For instance, Canada was the best performing developed market in 2016 with a gain of more than 25%. But with our home bias, the weight to Canada is reduced by two thirds.

Since we have no reliable way of predicting which country will be the best performer year of year, it makes sense not to deviate too far from the market portfolio.

DIVIDING UP THE SECTORS

Having a sizeable home bias means not only taking a big bet on a single country, but ending up with a disproportionate exposure to certain sectors.

In Australia’s case, the big four banks represented nearly 28% of the market, as of early 2017. Financials overall made up 38%, while materials stocks represented 17%.  In other words, two sectors made up more than half of the market.

To put that into perspective, financials represented just 19% of the global market while materials had a share of just 6%.

Another way of looking at this bias is to consider which sectors are poorly represented in Australia. For instance, information technology stocks made up just 1.3% of the local market, compared to 16% globally.

Chart 3 shows the natural market weight of sectors in a global portfolio. Chart 4 shows what happens when you have a 60% home bias. In other words, you end up taking a significant bet on financials and materials stocks, at the expense of other sectors like technology and healthcare. It’s a much less diversified portfolio.

DIVIDING UP THE STOCKS

We’ve seen that a home bias means concentrated bets on a single country and a couple of sectors. So it shouldn’t be a surprise that it also means you end up taking outsized bets on a handful of stocks.

With a 60% Australian home bias, a single stock—the Commonwealth Bank—will represent nearly 6% of your portfolio. That is more than the weight of the UK and Japan combined or more than your entire holdings in emerging markets.

Put another way, the top five stocks (the four big Aussie banks and BHP Billiton) will make up more than 20% of your portfolio. You will also more than halve your exposure to big overseas names like Apple, Microsoft, Amazon, Vodafone, Nestle and Volvo.

In fact, of the top 50 stocks in this Australian-biased “global” portfolio, all but four are local stocks, the exceptions being Apple, Microsoft, Exxon Mobil and Amazon.

Chart 5 illustrates how concentrated this portfolio becomes once the home bias is accounted for.

PUTTING IT ALL TOGETHER

Given investors tend to source most of their income from their home nation and hold most of their other assets there, you can see that this degree of home bias represents a very big bet on one country, a couple of sectors and a handful of stocks.

So the question then becomes what degree of home bias is acceptable. It shouldn’t be surprising that there is no one right answer to that. It depends on each individual investor’s tastes, preferences, circumstances and goals.

A good approach is to use a global market portfolio as your starting point. If you want to increase the expected return of your portfolio, you can use information in current market prices and company fundamentals to tilt your portfolio towards stocks with higher expected returns. Research has shown that small caps, low relative price and high profitability stocks deliver a premium over the market return.

While you may tilt your portfolio towards Australia for the franking credits or your familiarity with the stocks, it’s important to understand this has nothing to do with the expected return of your portfolio. It is just a preference. But it also comes at a cost.

In contrast, broad global diversification creates a portfolio that spreads its risk to more economies, to a greater number of stocks, to a wider range of companies and to a wider spread of sectors.

Again, there is no single right answer in terms of asset allocation. It will depend on the individual investor’s circumstances, goals and risk appetite.

But it is worth reflecting on the fact that an investor whose allocation is made up 60 percent of Australian equities is overweighting Australia relative to the global market by a factor of 25.

At some time or another, we all have to leave home.

• Source: Jim Parker, Vice President, DFA Australia Limited