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Wednesday, 23 July 2014

X is for Xenophobia

OK, Xenophobia isn't really a behavioral bias, but Home Bias is its equivalent - the tendency of investors to favor their home markets over foreign ones and to damage their returns, or at least increase their risks, in the process.

Example

Home Bias is a preeminent form of a wider bias - familiarity - which often governs our preferences. It's used by advertisers to get people to buy their products. For example, the mere exposure effect refers to our preference for things we've been exposed to, even if we haven't actually used them ourselves. Hence repeated advertising plugs for products - remember, if it didn't work they wouldn't do it.

As recently as 2007 US based investors had 80% of their portfolios in US based stocks, even though international diversification would provide downside protection and upside returns. But it isn't really surprising - similar effects can be found regionally; investors gravitated to their local Baby Bell telcos after AT&T spun them off and there's a clear correlation between local news channels reporting about local businesses and share price movements - and that's independent of the events being reported on, which often happened some time before.

Causes

Home bias is about familiarity; we're more comfortable with what we're familiar with and much more comfortable with that which we're personally familiar with. To some extent it's an illusion of control effect - simply knowing of a firm doesn't mean we know how it works any better than other corporations we're not familiar with, but as in so many other behavioral issues, we much prefer stuff we've observed ourselves rather than relying on abstract statistics and faceless numbers.

There is some evidence to suggest that home bias is even more irrational than it seems - fund managers exhibiting the behavior seem to be particularly risk averse and biased towards information that's less than reliable. So managers affected seem particularly keen on charts, technical indicators and place significant faith in the prognostications of economic thought leaders. Although they don't, as far as I can tell, use soothsayers.

Mitigation

International diversification has significant risk reduction benefits over long periods but, more importantly, learning to analyze stocks in terms of their performance and not how familiar you are with them is a proper attitude for an investor. Even relatively small firms are too complex for outsiders to really understand, so fooling yourself that familiarity breeds knowledge is a one way ticket to losses.

Home bias added to the Big List of Behavioral Biases.

4 comments:

  1. Nice - I was wondering how you were going to finesse X.

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  2. Doesn't the familiarity bias mean that stocks of this class will be permanently higher priced than those outside this class? Hence that investing in 'non-familiar' stocks is irrational because they'll never catch up?! Thus we're back to Keynes' 'beauty contest' observation - which you have discussed at length - i.e. is it 'rational' to buy a stock with an ugly name and wait? (and wait? and wait?). To another point, I don't see how one can characterize Warren Buffet as a patient 'value investor', no matter what he says. He makes no-lose deals that are only available to him (e.g. Goldman Sachs, General Electric) and most often, when he buys a company, he makes changes to ensure that it is well-run.

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  3. Hi Bernard

    It's a good point but I think there are downsides to punting on familiar stocks if it means they're higher priced. Firstly, higher priced stocks are more vulnerable to failures to hit earnings targets, so the associated losses are proportionately higher: people don't like being disappointed. Secondly markets go through fads and what may be familiar and popular today may be unfamiliar and unpopular tomorrow. Thirdly, the market will eventually price stocks roughly right, so even over-popular stocks will eventually see their prices moderate. In the end buying overpriced stocks can only be a successful strategy if you time your exit correctly; buying overpriced stocks for any reason reduces your margin of safety.

    On Buffet, well yes, his ability to exert control over the companies he buys means that he isn't really any kind of template for anyone. Even in his younger partnership days he was an activist investor, looking to catalyse change. Indeed, before him, Ben Graham was happy to agitate for change. But to be fair, it would be impossible for Berkshire to be a value investor, it's just too large. As he often says, he prefers to pay a fair price for a great business than a low price for a fair business, because of the compounding effect of higher growth. As Berkshire generally can't sell it makes perfect sense for them. The rest of us can only dream ...

    Tim

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  4. Since posting the above I've been reading Alice Schroeder's biography of Warren Buffet - "The Snowball" - where I'm up to 1956-58 and Buffet is in his mid 20's, and, though already hugely successful, is tiny compared to today. Accordingly, he was exceptionally assiduous and adept at finding obscure and 'ugly' stocks with ridiculously low valuations compared to their net worth and sticking with them long enough (in most cases) for the payoff. There does remain the question of what effect his buying these stocks for himself and his clients, along with his already substantial reputation for stock picking wizardry (going back to his childhood!) had on making the big payoffs occur?

    Bernard

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