Investors have been told, "Invest in what you know." While this may have been a good adage for avoiding investing in companies with no business models, it is a poor rule of thumb to use when building diversified portfolios.
Familiarity bias causes New Jersey investors to buy construction companies based in New Jersey simply because they feel like they know these companies better than financial services companies in Singapore. Similarly, investors in the San Francisco Bay area are more likely to be heavily concentrated in high tech companies. These are cases where limited experience can cause an investor to build a portfolio that is not the best mix of assets to help him or her meet important financial goals and objectives.
Investors who are comfortable with CDs or bonds often fail to allocate enough of their assets to the equities that will provide the important appreciation needed to help them meet their long-term goals. Because they lack the personal familiarity, most American investors are under-invested in foreign investments and even more are under-invested in the emerging market countries.
Most investors have over-weighted large cap US stocks whose names they recognize and whose products they use despite the fact that mid cap, small cap, and foreign stocks, on average, provide a higher rate of return over time.
Because of a familiarity bias, most investors have over-weighted large cap stocks whose names they recognize and whose products they use. This large cap bias occurs despite the fact that mid cap, small cap, and foreign stocks, on average, provide a higher rate of return over time.
Even in the realm of large cap stocks, investors most often invest in companies that are well-respected and considered to be the best in their field. This happens despite the fact that studies have shown that these industry leaders, on average, under-perform companies whose stock prices are temporarily depressed because the companies are having trouble.
A distressed company can move its stock price more by laying off a few hundred workers than a solid company can move its stock price by meeting its 30% revenue growth projection. The solid company is known for being a great company and the expected future growth has already been factored into the stock price. If the company reports 25% growth instead of 30% growth, investors will reevaluate the company's value and the stock price will drop accordingly.
By the time the average person sees a trend and recognizes a company's value, the pattern is just as likely to revert to the norm or go the other way.
Because investors concentrate their investments in what they are familiar with, they often don't even know that they are concentrated. We have seen investors who thought they were diversified because they were invested in several mutual funds with different names while each funds held similar underlying investments.
Studies have shown that when investors are given several choices, they tend to put an equal portion in each investment. Since many 401k plans don't have the same number of funds representing each asset class, naïve investors often build very unbalanced portfolios.
Measuring a client's asset allocation and diversification is not difficult. The critical step is crafting an asset allocation that best meets a client's financial goals.
Investors can avoid the familiarity bias that can cause an undesirable increase in portfolio volatility while also lowering returns either by broadening their investment knowledge or by seeking out trusted advisors who have that knowledge and experience.
Marotta Asset Management, Inc. of Charlottesville provides fee-only financial planning and asset management. Visit www.emarotta.com for more information. Questions to be answered in the column should be sent to email@example.com or Marotta Asset Management, Inc., One Village Green Circle, Suite 100, Charlottesville, VA 22903-4619.
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