Australian portfolios have a heavier home bias in equities than portfolios in countries such as the US and the UK, Vanguard data shows. This is despite the fact Australian markets make up only somewhere between 2 per cent and 3.5 per cent of the global total.
Disturbingly, data from the Australian Taxation Office and Self-Managed Super Fund Association show the more control or influence investors, rather than professional managers, have over portfolios, the greater this home bias, which creates a concentration of assets and increases specific risk exposure.
The bias (partially due to dividend imputation and the superannuation guarantee) is leading to Australian portfolios that conflict with the fundamental tenets of diversification and portfolio theory. Private fund managers and financial planners have both a professional responsibility and a need to be mindful of these biases in themselves and those they work with in order to reduce risk and achieve better outcomes.
The problem
The very cornerstone of portfolio theory is diversification. This simple ideal is based on statistical methods applied to countless models in numerous professional fields. Simply put, holding assets with varied sizes, types, industries, and geographic and economic homes creates a portfolio that will give the greatest amount of return for a given amount of risk – known as the ‘optimal portfolio’. Yet, even though this theory is accepted and well known within the finance industry, Australians still tend to concentrate their investments within local assets. This home bias creates a 70.4 per cent overweighting to Australian equities in the average portfolio, Vanguard data shows, with SMSFs (a good indicator of directed portfolios for large investors, as this is the preferred tax-advantaged, long-term vehicle) carrying an average of about 40 per cent of total portfolio assets in local shares. The SMSF home biases in cash, bonds, property and other assets aren’t far behind.
A paper called “The home-institution bias”, by Grant McQueen and Anders Stenkrona, published in 2012 in the Journal of Banking and Finance, concluded that this bias is mostly due to a familiarity investors have with Australian companies and brands and both an overconfidence and optimism regarding the prospects of such businesses. The research also found that “the home-institution bias is strongest among financially unsophisticated” individuals, suggesting it is also an illustration of the Dunning-Kruger effect, in which people over-estimate their degree of competence.
In addition, “The determinants of home bias puzzle in equity portfolio investment in Australia, by Kevin J. Daly and Xuan Vinh Vo, published in the International Review of Financial Analysis, in 2012, found that “the typical Australian investor undervalues the benefits of international diversification”. This only becomes more alarming when one considers the top-heavy high beta nature of the ASX, with its large oligopolistic companies, the heavy weighting of financials in the index, the influence of franking credit strategies, and the fact there are strong correlations between banking equities and property, increasing volatility of reducing the diversification of portfolios.
The solution
Professionals who understand distortion (as caused by tax incentives such as franking credits), behavioural finance, modern portfolio theory, and the incredible importance of diversification must work hard at conveying these concepts to the wider investing community. It’s a matter of professional responsibility. Financial planners who work with clients have a moral, ethical, and even legal obligation to do so, in order to act in the best interests of their clients.
Research shows existing biases will be extremely difficult to overcome, even for experts. Prominent academics agree financial planners and investment professionals in general will need to remain aware of their own susceptibility. Using an objective and rule-based investment philosophy strongly founded in modern portfolio theory fundamentals, and explaining this to clients, will be critical.
Benjamin Van De Weyer (GradDip.FinPlan, B.AppFin, AdvDip.FP, Dip.Mgmt) is a financial strategist with Platinum Strategies. He submitted the above paper for his FPEC CFP accredited master’s degree in financial planning at Griffith University.
