Familiarity Breeds Investor Mistakes

SUSIE GHARIB: When it comes to sports, most people root for the home team. And when it comes to investing, many people buy stocks in companies also on their home turf. This is called familiarity bias and some finance experts say it’s not a smart way to invest. I talked today with one of those experts, Nicholas Barberis. He’s professor at the Yale school of management, as we continue our series “Your Mind and Your Money.” We began the conversation by talking about the most common mistakes that investors make.

NICHOLAS BARBERIS, PROF., YALE SCHOOL OF MGMT: I think (INAUDIBLE) is something that we call home bias, which is when people invest in stocks they invest in, domestic stocks and they’re missing out on the benefits of international diversification. The second thing is something we call local bias, when people invest in stocks even within the United States, they invest in local stocks. Connecticut people invest in Connecticut stocks. And that’s bad because it’s tying your finance well being far too much to the condition of the local economy. And the third investing mistake is investing too much in the stock of your own company in your retirement plan which is again tying your financial well-being far too much to the fortunes of this one company.

GHARIB: But Nick, doesn’t this go against the advise of superstar investors like Peter Lynch who tell investors buy stock in the companies that you know. Invest in companies in your own backyard?

BARBERIS: I think it’s a difference between actually knowing and just thinking that you know. If you know a company incredibly well inside out, there might be a case for investing in that company. But I think what happens is people often think they know about a stock, but they actually don’t. That’s what the evidence shows for example with own company stock allocations.

GHARIB: So are you telling people that even if they have special incentives to buy the stock of the company they work for, that they shouldn’t take it?

BARBERIS: I would say that they shouldn’t take because if you do invest in own company stock, you’re exposing yourself to a bad scenario. If the company does poorly, you’re going to lose your retirement savings and you may lose your job. The way to avoid that disastrous scenario is not to invest in the stock, even if it’s offer at a discount.

GHARIB: Despite all of those horror stories of people investing their 401k money in companies like Enron and WorldCom, there’s still evidence that people are heavily investing their 401k money in the company that they work for. Do you think that this is a sign that people feel in times of uncertainty, that’s it’s better to go with something familiar?

BARBERIS: I do think that this is linked to the familiarity bias, yes. Stock investing is a very complicated business. So often we just fall back on what’s familiar. That makes us feel comfortable even if it’s bad for our long-run growth.

GHARIB: Going back to your point about international investing, some people might question the benefit of doing that because global markets are so connected. When one of them goes down, they all go down.

BARBERIS: If you look at how a stock market does over a week or over a month, yes, it’s s true that international stock markets do move together. But if you look at how a stock market does a year, over two years, then they don’t move together too much. So if you’re a long horizon investor, the benefits of international diversification are very strong. If you’re a shorter horizon investor, they’re not as strong, but they’re still there.

GHARIB: So what’s your advice to investors, how they can break this familiarity habit?

BARBERIS: I don’t think there are any simple tricks but what I always do is I just remind myself of the power of diversification. It’s a very powerful force. I think people should harness it and use it in their portfolios. Invest internationally, don’t concentrate your holdings in local stocks nor in the stock of your own company. I think the second thing is go with index funds rather than actively managed funds. Because of the evidence showing that the average actively managed fund will fall short of index funding.

GHARIB: So are you saying that they shouldn’t give their money to a professional money manager?

BARBERIS: I would advise against it again because of the evidence, the average professional money manager will under perform indices. Of course, some money managers do manage to beat indices over long periods of time, but it’s very hard for an ordinary investor like me to pick those people out in advance.

GHARIB: And you also told me that investors should stay the course. What do you mean by that?

BARBERIS: So I think often people set up very sensible asset allocations policies, but if sometimes goes wrong, if the market does poorly, they panic and they often revert to the more familiar things again which may feel good in the short run, but is bad for your long run wealth.

GHARIB: Nick, very good advice, thank you so much for coming on the program.

BARBERIS: Thank you.

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