Investors Face a Big Risk in Their Own Backyards: Hometown Bias
Your investment portfolio may be out of skew if you bet too heavily on the home team. Here's how you could be ramping up your risk without even realizing it.
With football season here, it is a great time for hometown pride; but is your portfolio too much of a fan of companies headquartered in your own backyard, and could that be setting you up for a big loss one day?
As an investment adviser, I have managed multimillion-dollar accounts in Pittsburgh, Philadelphia, Delaware, Southern New Jersey and Greater Atlanta, and it is all too common to find concentrated stock positions of companies that are headquartered in an investor’s home turf. The results can be quite unfortunate.
Investors Often Can Be Too Loyal to a Fault
Why do investors end up with large stock holdings of local companies? Several reasons, including:
Because it is given as a reward
Some of the largest employers across the United States are domiciled in major cities where they hire tens of thousands of local citizens. Many executives and high-level managers are rewarded periodically with stock of their employing company. Through employee stock purchasing programs, workers are able to allocate part of their salary to purchasing company stock at a discount; so it isn’t uncommon for employees across all levels to hold large positions of company stock in relation to their total assets.
Because it is what we know
Whether it is a large home-improvement company in Georgia, a global energy giant in Texas, a celebrated automaker in Michigan or a fruit company in California, many clients have portfolios heavily weighted in stocks and bonds of the major local corporation. Part of the reason may be there is a comfort level in what is perceived to be known and secure.
The fact that we see the expansion of a company on our daily commute, or the fact that a large local company has sponsored an event may give a sense of safety to investors who spend most of their time close to home. Everything from television commercials to personal in-store experiences to the feedback we get from family and friends who may work for the company can play a role in investor psychology; they may create a coziness that boosts sentiment in consumers and investors alike.
Because it is a part of our legacy
Transfers of wealth from one generation to the next can open the door for concentrated investment positions. Despite the fact that proper planning around wealth transfers can simplify the process of diversifying away from concentrations, the death of a loved one sometimes fosters deep emotional ties. It can be challenging to part ways with the stock that Grandma held or the stock that provided the dividend that historically paid the family bills for decades. Sometimes the inheritance is cultural, influencing investors to buy stock in the company that created the soda Mom used to drink or the utility company that employed Grandpa for 50 years. An inheritance can influence our thoughts about holding on to a concentrated stock position.
Why This Can Be a Problem
Concentrated positions can generate an enormous amount of uncertainty around your investment performance. There is a natural level of risk associated with investing that is called systematic risk. It is the unavoidable risk inherent in the market. The problem with concentrated positions is that they engender unsystematic risk — risk that can and should be diversified away. In other words, an investor with concentrated positions could take on both kinds of risks to their detriment.
When too much of your equity portfolio is allocated to a single stock, your portfolio may be dependent upon many factors that are beyond an investor’s control, including that company’s management, investor sentiment and Wall Street’s opinion of the stock. Likewise, placing too much weight in your fixed income portfolio on a single bond also can cause the portfolio to take on unnecessary risk associated with changes in interest rates and creditworthiness of the bond issuer.
Investing in the “home team” can lead to increased risk in terms of geography; regions of the country often are organically concentrated. For example, an investor in Silicon Valley may decide to invest in 10 different stocks that are in their backyard, all falling into the tech sector. Similarly, an investor in 10 different municipal bonds issued in an investor’s home state may carry the concentrated characteristics of municipalities governed by that state.
The missed opportunity alone can be a costly side effect of locally concentrating our investments. Some of the fastest growing companies today are based outside of the United States. By crowding portfolios too heavily with domestic stocks, you may risk losing out on opportunities inherent in investing internationally.
How Can This Be Resolved?
There are several ways to address concentrated positions. Three common strategies include:
Selling or gifting it: Selling concentrated positions reduces the holding, thus allowing you to redeploy cash into other areas of the market. Alternatively, gifting the holdings may provide tax benefits.
Using hedging strategies: A financial professional can set up counterbalances in a portfolio that are structured to pay off if the concentrated position loses value. These hedging strategies can cushion the overall portfolio, which may help to avoid losing great sums of value if the price of the concentrated stock or bond suddenly plummets. This added protection sometimes comes at a cost, but in many cases it can be constructed without any additional cost to the investor.
Not making it worse: It is important to be mindful of your overall concentration when purchasing new investments. Overall portfolio risk can be reduced by purchasing investments that are not correlated to the concentrated investment. An example would be purchasing bonds or alternative investments for qualified investors, if the concentrated investment is a stock, because stocks generally do not behave the same way that bonds and alternatives do over time.
Watching our favorite team blow the lead in the fourth quarter is painful, especially when they’ve given up the lead by making a risky play. Holding on to large positions because they were granted as a reward or form of compensation, inherited from a loved one or simply because of a proclivity to own stocks that are familiar could be signs that one’s investing behavior may be lining up for a risky play.
When portfolios are concentrated in the stocks and bonds of local companies, investors may be limited to a small pool of investment opportunities. Great wealth can be created and lost on concentrated positions; but by thinking rationally and avoiding concentrated positions, investors can help point their portfolios in the direction of victory.
The material presented in this article is of a general nature and does not constitute the provision by PNC of investment, legal, tax or accounting advice to any person, or a recommendation to buy or sell any security or adopt any investment strategy. Opinions expressed are subject to change without notice. The information was obtained from sources deemed reliable. Such information is not guaranteed as to its accuracy. You should seek the advice of an investment professional to tailor a financial plan to your particular needs.
Securities are not bank deposits, nor are they backed or guaranteed by PNC or any of its affiliates, and are not issued by, insured by, guaranteed by, or obligations of the FDIC, the Federal Reserve Board, or any government agency. Securities involve investment risks, including possible loss of principal.
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About the Author
Vice President, Investment Market Direct, PNC Investments
As a Vice President and an Investment Market Director in the Southeast market for PNC, Justin Sullivan provides investment leadership in the creation and implementation of investment strategies. Justin also serves as an investment adviser for complex accounts. Justin works with a team of investment advisers, specialists in financial and estate planning, trusts and banking services to help clients achieve their financial objectives.