Investor Psychology

Too Close to Home

Buying investments we know best hurts diversification.

If only familiarity did breed contempt, we might all be better investors. But the reality is just the opposite: Familiarity breeds contentment because human nature prompts us to feel comfortable with things we know. As a result, instead of buying investments that could yield superior results, we gravitate toward the ones we know best.

Consider an experiment in which a university student took four courses. In one she attended just a couple of classes, in the second she attended six sessions, in the third she showed up for ten, and in the fourth she made an appearance at every class. The student never talked to any faculty members or classmates. At the end of the semester, faculty and students were asked how attractive they thought she was. The student was rated more attractive by those in the classes she had attended more frequently "simply because people had been exposed to her more often," says Yale University finance professor Nicholas Barberis.

This "exposure" effect is the best explanation for a stubborn investing bias, Barberis explains. It's called the home bias; it hurts diversification, and it's particularly powerful in connection with international investing, he says (learn more in this video).

At one point during the 1980s, for example, Sweden's stock market accounted for less than 1% of the value of the world's markets. Nevertheless, most Swedes were 100% invested in Swedish stocks. Saab and Volvo may have been fine investments, but Swedish portfolios would have benefited from holding a smorgasbord of global stocks. Investing in the stocks of companies headquartered in foreign countries doesn't just give you more opportunities to pick winners. For instance, some countries have faster growth rates, meaning that stock prices may rise more quickly.

Worst offenders. The home-country bias is universal, and U.S. investors aren't the worst of the lot. At the time of a 2008 study by Wilshire Associates, the U.S. held about 43% of the world's stock-market value, and U.S. investors held 70% of their stock portfolios in U.S. companies. But in Japan, which had 10% of the world's market value, Japanese stocks made up 63% of portfolios.

And investors tend to own companies that are based near where they live. For example, one study looked at investments in regional Bell holding companies, the "Baby Bells." In all but one state, the study found, locals tended to hold more shares of the nearest Baby Bell than the others.

A particularly harmful home bias involves owning too many shares of your employer's stock. Holding a big slug of a single stock is risky enough. But if your employer falters, you will lose not just money -- you could also lose your job. A 2001 study found that Coca-Cola employees allocate 76% of their discretionary retirement contributions to Coke shares -- and only 16% thought that such a big bet was riskier than a well-diversified portfolio.

Financial planners say that prying clients loose from owning huge amounts of their employer's stock is tough. When logic fails to sway clients, advisers will often try to reduce the stake a little at a time under the guise of profit-taking or dollar-cost averaging. Still, selling the stock sometimes causes "too much emotional trauma," says planner Jerry Verseput of El Dorado Hills, Cal. In that case, Verseput uses options to hedge against a big price drop.

To separate clients from their home-country bias, planners sometimes show them a world map on which each country's size is based on its stock market's value. Since 1945, the U.S. share of world markets has been cut in half, from 90% to 43%, demonstrating that the U.S. isn't as dominant as it once was. Ted Feight, a financial planner in Lansing, Mich., finds that certain clients who shun overseas stocks change their minds when asked: "Would you play golf with only one arm?"

Kiplinger's is partnering with Nightly Business Report on the "Your Mind & Your Money" series, funding for which is provided by the FINRA Investor Education Foundation. For companion video reports, tune in to NBR on your local PBS channel June 14 and 28.

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