Home bias is a cognitive bias that increases the risk of investments and reduces their profitability.
Domestic bias is a tendency to develop preferences for investments in assets close to us, such as the country where we live or sectors in which we operate. For example, if we are in Europe, it consists in investing in a French telecom company rather than in an American technology company, even if, in fact, the development prospects of the American technology company would be significantly better.
It may also lead to more negative assumptions in the analysis of the quality of an investment in a more distant country when in fact all the criteria and other rational indicators would be more positive. For example, we would tend to increase the assumption of risk of default in a more distant country.
In portfolio management, domestic bias is defined by the difference between the shares of foreign assets predicted by portfolio theory and the units actually invested in foreign securities. The larger this gap, the greater this bias.
People who are affected by this bias tend to invest heavily in a sector close to them or in a country from which they come or close, and to diversify their investments less. Thus, an American will be more likely to invest in the United States, a Frenchman in France or a Japanese in Japan. If we have spent part of our career in the agri-food industry, this bias will lead us to invest more heavily in it.
This type of bias therefore increases the risks because it leads to a reduction in portfolio diversification. It also reduces the return on investment as it reduces the share of potentially more profitable investments but more remote or less known.
This bias can affect both experienced investors and individuals, including high net worth investors.
How can we reduce this domestic bias or this “home bias”?
Several solutions are possible, here are some of them, to be selected or adapted according to the specific case to be addressed:
First, to reduce such cognitive bias, it is necessary to establish a list of investment criteria. These criteria must include factual figures directly comparable from one investment to another, regardless of the sector or country. It is then desirable to weight these criteria before even starting to make a list of investments to be analyzed. This method will make it possible to obtain a coefficient to classify the different investments.
In terms of portfolio management, it is possible to compare the shares held with other more diversified types of portfolio, including, for example, shares from different sectors or international equities.
It is also often desirable to combat other types of cognitive bias such as less confidence in financial information from abroad. However, today, regulations and transparency of information have made significant progress in many countries. Investments have therefore often become more regulated, more transparent and therefore less risky.
It is also desirable to control one’s exposure to the media. Indeed, they tend to publish bad news more often than good news. However, the information we receive from abroad is generally less frequent. The share of bad news is therefore frequently exaggerated. It is therefore a question of being more objectively informed about other sectors or countries, or of reducing exposure to certain types of media.
Talking to an advisor, expert or other investors who know other sectors or countries can be useful. This can bring us a different, sometimes contradictory point of view. Seeking contradictory points of view often makes it possible to reduce this type of bias.
Finally, Neurovalue develops tailor-made Cognitive Profilers to identify an unconscious preference for investments in certain sectors or countries. Cognitive Profilers can also make it possible to quantify unconscious associations that can irrationally increase investment in certain types of related assets.