All over the world, investors invest too much money in their domestic stock markets. Home bias, as it is known, isn’t just risky for individual investors – it may be distorting global markets.
That's according to Victor Haghani, the founder of London-based investment firm Elm Partners. Haghani notes that studies indicate US equity investors invest about 80-85 per cent of their money in the US market – markets outside the US are an afterthought, even though they account for almost half of global stock-market capitalisation.
Equity investors in smaller markets such as the UK and Canada allocate about half of their money to their domestic markets – an even greater degree of home bias than that displayed in the US, given the UK and Canada account for only 5 and 3 per cent respectively of global stock market capitalisation. An equity investor in Ireland who allocates even 10 per cent of their money to the domestic market is similarly guilty of enormous home bias, seeing as the Irish market only accounts for a tiny fraction of the global equity market.
This isn’t a good idea. Japanese investors who ploughed most of their money into the domestic market in the 1980s are still paying the price, with the Nikkei having lost almost half of its value since its 1989 peak. That’s an extreme example, but countries such as Germany, France, Spain and Italy have all experienced 50-year periods where stocks failed to keep up with inflation. Quite simply, home bias is risky.
Big gets bigger
Despite the risks of home-biased investing, people all over the world do it. That prompted Haghani to ask: if everyone is doing it, does it matter? “Or if everyone equally over-weights their domestic market does it all pretty much wash out, with the over-weights cancelling out the under-weights?” Short answer: yes, it matters, especially when one market (the US) is so much bigger than every other.
Haghani asks investors to first imagine a world with no home bias, and 11 national markets with a total value of $100. One market dominates and is worth 50 per cent of the total, while the remaining 10 small markets represent 5 per cent each.
Now, imagine we flip a switch and turn home bias on. Investors in the big market now want to be 80 per cent invested in their domestic market, instead of 50 per cent. Investors in the 10 smaller markets are even more prone to home bias and want to put half their money into their home market, way above their 5 per cent weight. The rest of their money is distributed according to market capitalisation weights.
The mathematically-inclined can do the calculations and see the end result, but essentially what happens is that the big country sends 20 per cent of its money to other countries while receiving slightly more than 25 per cent of investments from the smaller countries. This creates a supply-and-demand problem: too much money will flow to the big country while not enough will make its way into the smaller markets. Consequently, market values must change, with the big market going up in value relative to the small markets.
Overvalued and undervalued markets
The big market referred to in these back-of-the-envelope calculations, of course, equates to the US stock market. If Haghani is right about the direction of fund flows, then the US stock market should be getting progressively more overvalued over time, while the rest of the world becomes cheaper relative to the US. Is this the case? Most market watchers would agree that the US, which has trounced the rest of the world over the last decade, looks much more expensive than most international markets. The US market currently has a cyclically-adjusted price-earnings (Cape) ratio of 29, according to the latest data from German firm Star Capital – that's way above historic norms, almost double that seen in emerging markets and well above the average ratio of 18.8 seen in developed European markets. According to Oxford Economics, the MSCI All-Country World Index's cape ratio is 19, representing "a near record gap" with the S&P 500. Now, the Cape ratio has many critics who point out its various imperfections, but other valuation measures also indicate a large gap. The US trades on a forward price-earnings ratio of 17.4, whereas equities in the euro zone, the UK and Japan trade on around 12- or 13-times estimated earnings – a valuation gap that is close to record levels. Looking at price-book ratios, the US has the biggest valuation premium over the aforementioned markets since at least 1980.
Now, there are very good reasons why these valuation gaps exist. Value investors have been warning about US valuations for years, but US stocks have nevertheless outperformed non-US stocks by 135 per cent over the last 10 years. About two-thirds of that outperformance is due to higher earnings growth in the US, Haghani acknowledged in a separate note in August, with the remaining outperformance attributable to relative changes in valuation multiples. Might sector differences – specifically, the fact that the high-margin technology sector is much more prominent in the US than in other international markets – account for the valuation gap? Not really, Haghani found, adding that factors such as the much faster pace of stock buybacks in the US as well as the home bias of US investors are more likely to be explanatory factors.
If home bias is distorting global market valuations, how can it be remedied? Many commentators complain that the huge growth in passive investing strategies that track market indices is causing distortions in markets, but home bias is proof that “not indexing can itself lead to significant distortions”, says Haghani. If there was less home bias and more index investing whereby everyone put their money into an all-world index, he argues, then global market valuations would more closely reflect economic realities.
The irony is some prominent indexing advocates seem blind to the perils of home bias. The late Vanguard founder John Bogle used to recommend US investors forget about global indices and instead put all their money into the US market. Warren Buffett is similarly guilty of home bias – the instructions in his will state that when he dies, 90 per cent of his inheritance is to be invested in the S&P 500 with the remaining 10 per cent in short-term government bonds.
If Haghani is right, then such home bias is not only risky for individual investors, it is distorting global market valuations. Buffett is right to make the case for indexing, says Haghani, but it’s a pity he didn’t encourage his “disciples” to “take a more worldly perspective”.