How Investing Locally Could Backfire

It's no secret that investors tend to favor their home country. Now, new research shows that they also tip their portfolios in favor of companies based in their home states.

In the study "Long Georgia, Short Colorado? The Geography of Return Predictability," researchers examined the holdings of more than 75,000 individual investors between 1991 and 1996 and found that investors put an overabundant amount of their money in their home states. For example, investors in New York bought stocks of companies headquartered 750 miles from home, on average (had they randomly picked stocks, that distance would have been an average of 1,055 miles).

The reason, writes Mark Hulbert of the Hulbert Financial Digest newsletter, is familiarity. "Often, the investors who buy shares of small companies—particularly those that aren't tracked by Wall Street analysts—are those who live nearby," he says.

Sophisticated traders are already trying to exploit the study's findings. If, for example, a state's economic climate is worsening, that most likely means a decline in the wealth of its investors—the same investors who hold a disproportionate share of local companies. As a result, these investors may sell their shares, causing the state's stocks to lag behind the performance of the overall market. That's a long chain of cause and effect, but Hulbert says the study's implication may be that it's wise to guard against local bias. "Otherwise, you may be missing opportunities in the broad market, all while rendering your portfolio vulnerable to the economic conditions of your own little corner of the world," he writes.

That's exactly the argument Keith Walter of the Julius Baer Global Equity fund recently gave for investing in a global fund.