Normal Investors - Familiarity

Credit: Suat Eman at FreeDigitalPhotos.net

Imagine you are just getting home after a very busy and stressful day at work. You just closed the door to the garage, dropped your bag on the couch, and are making your way up the stairs towards something you value deeply - comfortable clothes. Yep, there’s that old pair of jeans you wore yesterday. You know the ones with the slightly worn knee and the stretched out belt loop from where you like to rest your thumb? Best of all, they’re everso slightly stretched out from your wearing them yesterday. Don’t worry, I won’t tell anyone!

Of course there’s a similar feeling when you return home after travelling, whether for business or for pleasure. That moment after you’ve filled the laundry bin, returned your toothbrush to its normal spot, and have finally put up the suitcase. Oh it’s nice to see your shower, your couch, and most of all, your pillow! Wouldn’t you agree?

As you’ve undoubtedly gathered, I’m talking about familiarity. Whether a pair of comfortably worn jeans or your old friend of a pillow, familiarity feels good. It’s what you know. It’s what feels right. It’s what feels safe. Familiarity is also the third tendency that I present to you as a trait many normal investors have.

I would offer that many people go with what they know, especially when they are unsure of what is best. Consider some research done by Vanguard back in 2010 that found that Canadian investors were 65% invested in Canadian stocks, U.S. investors were 72% invested in U.S. stocks, and Australian investors were 74% invested in Australian stocks. Canadians, Americans, and Australians certainly have their differences, but do you really think the before mentioned investment allocations coincidentally showed that degree of “home bias?” I don’t. Investors were investing in what they felt they knew.

To take this a step further, let’s spend a moment on company stock. Regardless of the company, most people I come in contact with who work for publicly traded companies tend to own stock in their employers. Why? Do they think their company’s stock is going to really pop? Sometimes. And sometimes, they’re right, but sometimes they’re not. I’ve met many successful employees and successful investors who have a significant portion of their wealth in “their” company stock, and they desire to continue holding that stock even when they are no longer actively working for the company. Why? I think it’s because it’s easier for someone to feel safe investing in a company that they know a little about rather than the broader market which they may not know as well. Employers are aware of this, too, and that’s one reason employees are often incentivized with company stock in an attempt to align the employee’s financial success with the company’s future financial success and encourage hard and good work from employees.

(As an aside, I attended a lecture given by a professor from the Wharton Business School earlier this year, and he shared that a study was currently being done on what stocks were the hardest to get investors to diversify out of based on their location. #2 was supposedly getting a Seattle resident to sell some Microsoft stock (Microsoft is based in Seattle). Guess what #1 was? Getting stock in The Coca-Cola Company out of an Atlanta resident’s hands! Do any of my local readers here have any Coca-Cola stock? If you don’t, I bet you have friends and family who do!)

Familiarity feels good. Investing in companies that are based in your country is normal. Investing in the company you work for is normal. Investing in companies that are near and dear to your city or state is normal. However, you have to be careful when considering the investment risks of being overly concentrated in a single stock, a single sector, a single asset class, or a single country’s stocks. The risk-adjusted returns of a diversified portfolio are often still king. Going with what you know, what feels right, and what feels safe can be a crutch and a safety blanket, but what if your crutch was named Enron? What if you’re a Greek citizen and Greek companies are what you know? What if your paycheck was coming from Lehman Brothers, the pension benefit you were working for was guaranteed by Lehman Brothers, and most of the stock you owned was invested in Lehman Brothers stock? It’s normal to invest based on familiarity, but that may not always be best.

There’s nothing I hate more than when a grocery store I frequently visit decides to remodel. It’s frustrating. It doesn’t feel like it used to, I don’t understand the layout, and I don’t know where anything is, but I will get used to it. Eventually the new layout will feel familiar. Sort of like an investment portfolio that has recently been adequately and prudently diversified, eventually the new layout will feel familiar.

-Tom

Next up: overconfidence

Normal Investors – Overreaction and Underreaction

The second tendency that I would suggest many normal investors have would be the tendency to overreact and underreact. (If you missed out on the first part of my behavioral finance series on five of the characteristics most “normal” investors seem to have, you can catch up right here!) Of course, before I dive into how investors can, and often do, overreact, I must consider my own behavior this past weekend…

As many of you know, my wife and I are fairly avid UGA fans. Fine, fine, we’re full-fledged Georgia Bulldog fanatics! I mean I got up at 3:30 a.m., left my home at 4:00 a.m., and arrived in Athens at 5:38 a.m. to claim a small piece of generally lucky land between two curbs that my family, friends, and I have tailgated at for the last six years for a game that kicked off at 3:30 p.m. Who would do that? Well evidently me and several thousand more of my closest Georgia brethren considering “our spot” was already taken by someone even crazier than me! Oh the genuine rage I felt as my low beams displayed his silhouette on my very own game day island! That didn’t keep my group down though as we continued with our pregame festivities in the middle of what must have been a monsoon; festivities that included steak, seafood, a houndstooth cake and elephant ears (so we could eat the opposing mascot), and a crimson punch (so we could drink the opposing mascot). Then there was the wretched game where our beloved and favored Bulldogs were supposed to avenge our painful championship game defeat a few years ago only to be shellacked, annihilated, and otherwise dismantled by one of our hated rivals from the West.

A lot of pretty normal people are college football fans, but there is a good portion of that last paragraph that might lead you to believe that I'm a little bonkers. My point is that sports fans often overreact. They react with way more pride and celebration after victories and way more dismay and disgust after losses than they probably should. Many investors do the same thing. Investors can have a good experience with a product or service, and then they suddenly want to buy some stock in the company that made the product or delivered the service based solely on their positive experience. Investors can enjoy some decent growth and gains in a stock they have previously bought a little bit of, and they can develop an insatiable and blind appetite for more and more of that very same (and already appreciated) stock. Investors can get more and more excited about a roaring bull market (think the Dotcom Bubble) and want more and more stock exposure in their portfolios even though the investment return party has been going on quite a while. Of course, investors can also panic more than a Southerner in a snowstorm and completely sell out of a position based on the rampage of some talk show host who is trying to get ratings. A chain email about tax rates going up or a presidential or congressional proposal can also get an investor to sell out of everything just as if they’d seen a mouse, snake, or spider.

Overreacting as an investor can be dangerous. It can lead to one-way bets. It can lead to frequent trades which are costly and tax-inefficient. It can lead to dangerous concentration in one stock. It can lead to dangerous concentration in cash. There are certainly times as an investor where swift and substantial action is needed, but if you are investing prudently, that shouldn’t be very often. Part of my job is being the voice of reason, being the voice that isn’t that worried about the scary financial spider that man on the radio was yelling about, and being the voice that isn’t so sure that someone has really found that Fountain of Youth your neighbor confided in you about. Overreacting about football is one thing - it’s a game. Overreacting as an investor is another - it costs real dollars and cents.

The second part about normal investors reacting is actually underreacting. I like to illustrate this by considering Western Union’s lack of interest in Mr. Bell’s telephone patent, IBM’s lack of interest in the Xerox machine, and Kodak’s lack of concern with digital technology. In my own experience, I have found that investors rarely underreact when it comes to their investment portfolios, but instead they underreact when it comes to their own financial trajectory. I stand by that spending all that you are making is not a terribly successful retirement strategy, going into retirement with a large mortgage remaining is not a positive for your retirement cash flow, and that recurring credit card debt is one of the worst things since Brussels sprouts, but not everyone adequately reacts to those messages. Similar to ignoring a scratchy throat a few mornings in a row or that ant you saw in your kitchen the other day, underreacting to financial matters that could be nipped in the bud now can lead to some real serious financial problems in the future.

It’s normal and human to not always react in the optimum way, but financially, it’s important to try to. Maybe it’s all the children’s books I find myself reading now, but I kind of think of Goldilocks. Don’t overreact, don’t underreact, try to react juuuuuust right!

-Tom

Next up: familiarity