Buy what you know. It’s an old admonition, and on the surface a sensible one. Focusing your investments on those companies that you’re most familiar with should help mitigate the risk of a bad investment choice.
Unfortunately, like a lot of conventional wisdom, it’s wrong. Concentrating your portfolio to local investments, while comforting, is a mistake for two reasons:
1. Investors often exaggerate the benefit of physical proximity. The fact that a company is headquartered in my hometown probably doesn’t make me any better qualified to judge its investment prospects. If it did, everyone who lived in Seattle could simply day trade Microsoft and Nike for a living.
2. Focusing too much on local companies leaves investors with an overly concentrated portfolio. One investor I knew had a disproportionate share of his portfolio in companies domiciled in his mid-sized southern town.
While this provided some psychological comfort, it was a seriously flawed strategy, as the relatively small size of the business community led him to over invest in a very narrow list of companies. In fact, investors who disproportionately favor local investments will struggle to assemble a well-diversified portfolio, taking on unnecessary risk in the process.
A slightly less dangerous, but more common, version of this approach is the “home country bias.” This phrase refers to a very widespread investor mistake: over investing in one’s own country.
This habit is even more dangerous for investors outside of the United States. Australia provides a good example of why. While Australia is the epitome of a modern and fiscally sound economy, it’s a very concentrated one, and so is the Australian stock market.
Financial firms make up roughly 50% of the market’s capitalization, while mining companies are another 20%. Sectors such as consumer discretionary, telecom, and healthcare make up 10% or less of the market. In other words, Australian investors with a home country bias are effectively betting their equity portfolios on just two industries, both of which happen to be very cyclical.