Should your shares be girt by sea?

The Australian market was a laggard in comparison. The S&P/ASX 200 rose 6.9 per cent in the three months to March.

The local market lagged world markets last year as well. The S&P/ASX 200 fell 10.5 per cent, compared with a fall of 5.3 per cent for the MSCI World Index.

This poses a question for investors: Assuming equity markets continue their recovery, is the strong home bias of Australian investors going to hold back returns?

Among Australians who hold equities (outside their superannuation funds), the domestic holding is 81 per cent of the total, whereas the Australian equity market makes up less than 2 per cent of global equities.

Investment managers and equity strategists started the year with a very cautious view about the outlook for equities. However, the strong March quarter has given them some hope that we may not be seeing a repeat of the false dawn of 2011, when markets went up early but fell away badly in the middle of the year.

In a commentary that Perpetual sent to investors in its Concentrated Equity Fund at the end of February, the fund manager says the outlook for the equity market appears to be improving. "The flow of resilient economic data from the United States and efforts by eurozone leaders to stabilise their economy may drive positive changes in investor sentiment towards risk assets," it says. "Chinese monetary easing may also benefit global markets."

The chief economist at AMP Capital Investors, Shane Oliver, says economic news has been positive. "There is greater confidence of continued growth in the United States and some lessening of concern about China," he says.

"Shares are very cheap relative to bonds. This means that the expected earnings yield on shares is higher than the rate being offered on government bonds."

If investors are encouraged by such commentaries and thinking about shifting some of their money from cash back into shares, they should give some thought to the issue of home bias. Most investors prefer to invest in local assets but this might not always produce the best outcome.

The senior investment strategist at MLC, Michael Karagianis, says the difficult investment environment of the past couple of years has brought a trend towards higher domestic asset exposure, particularly in shares, bonds and cash, at the expense of greater diversification.

"A home bias is a classic response to periods of high investment uncertainty, particularly when much of the perceived investment risk comes from overseas markets," he says.

"However, increasing domestic asset exposure will not necessarily protect investors. In fact, it could increase rather then decrease overall risk."

He says the Australian sharemarket is highly concentrated and highly exposed to international risk factors by virtue of its high commodity and property exposure.

"The higher dividend yield of the Australian market is attractive but it won't necessarily guarantee better overall performance. It hasn't over the past three years, with the Australian sharemarket one of the poorest performers and also one of the most volatile markets.

"Increased international sharemarket exposure can boost the defensive characteristics of a portfolio by virtue of greater country and sector diversification," Karagianis says.

To achieve an average return of 7.6 per cent a year from Australian equities in the past three years, investors have had to take a lot of risk. The volatility of the S&P/ASX 200 during that period was 14.8 per cent, according to Morningstar (volatility is calculated by measuring standard deviation, which is the amount returns will deviate from the median in any given year).

The volatility of Australian small-cap stocks during the same period was 20 per cent.

The volatility of international equities was 11.1 per cent. Investors have been getting a better return from overseas shares during the past year and taking less risk to get that result.

The head of investment strategy at UBS Wealth Management Australia, George Boubouras, says the key to lowering the volatility of an investment portfolio "is to diversify across and within all asset classes". "Exposure to domestic and international equities, as well as other assets, helps lower volatility."

The communications director at Dimensional Fund Advisors Australia, Jim Parker, says there may be good reasons to stick close to home if you are an Australian investor.

"Our dividend imputation system delivers tax-effective yield to share investors. Familiarity with local markets is a legitimate reason for sticking close to home," Parker says.

"But a big home bias can have unexpected and potentially dangerous consequences. The main risk is that share investors end up with very concentrated exposures to particular companies and industries."

Just 10 stocks make up half the market capitalisation of the Australian sharemarket, as measured by the S&P/ASX 300 Index.

Those stocks are: the mining companies BHP Billiton and Rio Tinto, the four major banks, Telstra, Wesfarmers, Woolworths and Newcrest Mining.

The Australian equity market is a very concentrated bet.

The materials sector (which includes mining companies) is more than 20 per cent of the total market. The financial sector makes up 30 per cent.

"A portfolio with a 60 per cent allocation to Australian shares, which is common in many superannuation funds, will underweight such names as Apple, Microsoft, General Electric, IBM and Exxon Mobil," Parker says.

"So the advantage of franking credits comes at the cost of high concentration risk.

"We do not know if materials and financials will continue to perform as strongly as they have. That is why it makes sense to widen the net a little further. As we saw last year, the Australian equity market may lag overseas markets."

Some commentators believe that maintaining a home bias is a defensible position.

An analyst at Russell Research, Geoff Warren, wrote in a 2009 paper that the case for a major reallocation to international assets is not always sufficiently compelling to motivate change.

"A wholesale restructure to a global portfolio would be a very bold move," Warren says.

"Australian equities benefit from dividend imputation and managed funds investing in Australian equities have lower fees and more successful active management,"

he says.

"When the choice is between two options, neither of which is always superior, there is an understandable tendency towards home bias."

Why investors stay close to home

Anil Mishra, from the school of accounting, economics and finance at the University of Southern Queensland, gave a paper at a 2007 Centre for Financial Studies conference that set out to explain the causes of home bias.

Investors hold stocks that they know because they tend to think the risk of stocks they do

not know is extremely high.

Another factor is information asymmetry, which means that investors have better information about domestic stocks. This leads investors to expect that returns on domestic stocks will be considerably higher than returns in foreign markets.

Home bias can also arise because of the higher cost of trading foreign equities and uncertainty about the tax treatment of foreign holdings.

Investors dont care all that much about diversification, despite all the advice they get

from investment professionals that it is an important part of building a successful portfolio.