People prefer things that are familiar to them. They root for the local sports teams. They like to own stock in the companies they work for.
Their sports teams and employers are familiar to them.
When you are faced with two risky choices, one of which you have some knowledge about and the other of which you have none, you choose the one you know something about. Given two different gambles where the odds of winning are the same, you pick the gamble that you have more experience with. In fact, you will sometimes pick the more familiar gamble even if its odds of winning are lower.
Familiarity Breeds Investment4
There are tens of thousands of potential stock and bond investments in the United States. There are also that many choices overseas. So how do investors choose? Do you analyze the expected return and risk of each investment? No, you trade in the securities with which you are familiar. There is comfort in having your money invested in a business that is visible to you.
As an example, consider the breakup of AT&T. In 1984 the government broke up AT&T's local phone service monopoly into seven regional phone companies known as the baby bells. Twelve years after the breakup, who owns these baby bells? It turns out that investors are more likely to own shares in their local phone company than the phone company of another region—they are more comfortable investing in the more familiar company.
The inclination to invest in the familiar causes you to invest far more money inside the borders of your own country than traditional ideas of diversification would recommend. In short, you have a home bias because companies from your own country are more familiar to you than foreign companies.
Figure 11.2 illustrates the home bias.5 The stock market in the United States represents 47.8% of the value of all stocks worldwide. The stock markets in Japan and the United Kingdom represent 26.5% and 13.8%, respectively, of the worldwide stock market. Therefore, to fully diversify a stock portfolio, you should allocate 47.8% of your portfolio to U.S. stocks, 26.5% to Japanese stocks, and 13.8% to U.K. stocks. In fact, modern portfolio theory suggests all investors should have this allocation! But do investors use this allocation? The answer is a resounding no. The stock portfolios of U.S. investors are 93% invested in U.S. stocks, not the 47.8% suggested by portfolio theory. Japanese investors are 98% invested in Japanese stocks. U.K. investors have 82% of their stock portfolios in U.K. stocks. Investors purchase the stocks of companies that are familiar to them, and people are simply less familiar with foreign firms.
People invest some, but not much, money in foreign companies. What types of foreign stocks would you buy? Those that are familiar to you. The foreign companies that are most familiar are the large corporations with recognizable products. For example, non-Japanese investors tend to own the large Japanese companies.6 The smaller Japanese firms that attract non-Japanese investors have high levels of exports. Investors choose stocks that are familiar to them in both domestic and foreign markets.
Americans pick familiar foreign firms, but they bias their portfolios toward U.S. companies. They also tilt their portfolios toward local firms. For example, Coca-Cola's headquarters is located in Atlanta, Georgia. Investors living in Georgia own 16% of Coke,7 and most of these investors live in Atlanta. Coke sells its products worldwide, but the people most familiar with the company own a large percentage of it.
Professional money managers also invest in the familiar. Even though U.S. professional investors have access to vast information sources and analysis tools, they still tilt their portfolios toward local firms. This is especially true for small local firms and riskier firms. On average, the companies that a professional money manager buys are headquartered 100 miles closer to the manager's office than the typical U.S. company.8
Familiarity Breeds Investment Problems
What company are you most familiar with? Generally, you are most familiar with the company you work for. This familiarity causes employees to invest their pension money in the company stock. For example, most company 401(k) pension plans allow employees to invest money in options like a diversified stock fund, a bond fund, and money market instruments. One common option is the company's stock.
Modern portfolio theory suggests that employees diversify their retirement assets, selecting diversified stock, bond, and money market funds as needed according to their risk tolerance. Selecting the stock of one company is not diversified. Considering that people already have their labor capital tied up in the company, to fully diversify, they should avoid investing their financial capital too.
If your job and your retirement assets depend on one company, you could be in for a shock. Consider the plight of the employees of Color Tile, a Fort Worth, Texas, home decoration retailer. Because the company has declared bankruptcy, many of the 1,362 pension plan participants may lose both their jobs and much of their retirement money—the $20 million pension plan was heavily invested in company stock. The stock of companies declaring bankruptcy frequently becomes nearly worthless in bankruptcy court. Even large established companies can go bankrupt. For example, on April 6, 2001, Pacific Gas and Electric, California's largest utility, filed for bankruptcy.
Your company doesn't have to go bankrupt for you to be adversely affected. Several employees of Miller Brewing Company were going to retire early. Philip Morris owns Miller. Unfortunately, these employees had most of their 401(k) investments in Philip Morris stock. Near the end of 1998, Philip Morris stock peaked at $56 a share. By the end of 1999 the stock had fallen to $23. If these employees has been planning to retire on a nest egg of $500,000, that egg would have shrunk to nearly $200,000. This 59% loss occurred during a time when the general stock market (the S&P 500 index) advanced by 26%. What are the consequences for these employees? Early retirement will probably not be an option. Fortunately, Philip Morris began a partial rebound in 2000. By year end, the stock had risen to $44.
Just how common is it for employees to invest their retirement money in their company's stock? In a survey of 246 of America's largest companies, 42% of the total 401(k) plan assets were invested in the company stock.9 Employees themselves make this decision. They like investing in the company stock because it is familiar.
When you are familiar with something, you have a distorted perception of it. Fans of a sports team think their team has a higher chance of winning than those who are not fans of the team. Investors look favorably on investments they are familiar with. They believe that familiar investments will deliver higher returns and that they have less risk than nonfamiliar investments. For example, Americans believe that the next year's U.S. stock market will perform better than the German stock market. Meanwhile, Germans believe their stock market will perform better. Employees believe that the stock of their employer is a safer investment than a diversified stock portfolio.
The brain often uses the familiarity shortcut to evaluate investments. This can cause you to invest too much money in the stocks that are most familiar to you, like your employer's stock. Ultimately, this leads to underdiversification. You allocate too much of your wealth to your employer, local companies, and domestic stocks.
The next part of the book broadens the scope of consideration to the sweeping impact of the arrival of the Internet and how that has magnified your psychological biases.