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Investors Confuse Familiar With Safe

INVESTORS CONFUSE THE FAMILIAR WITH THE SAFE


By Larry Swedroe

 

When ATT was broken up shareholders were given shares in each of what were called the Baby Bells. A study done a short while later found, however, that the residents of each region held a disproportionate number of shares of their local regional Bell. Each group of regional investors was confident that their regional Baby Bell would outperform the others.

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How else can you explain each investor having most of their eggs in one baby basket? Other examples of familiarity breeding investment are that Georgia residents own 16% of all Coca-Cola stock, and people in Rochester tend to own stock in Kodak and Xerox. This is not Lake Woebegone where all Baby Bells can outperform the average of the group. This story is a good analogy for the way domestic investors view non-domestic assets.

 

It seems to be a global phenomenon that most investors hold the vast majority of their wealth in the form of domestic assets. While the data is a bit stale, I don’t believe that much has changed. In 1990 the domestic ownership shares of the world’s five leading stock markets was United States 92%, Japan 96%, UK 92%, Germany 79%, and France 89%.2 With the relative freedom of capital to travel around the world, the lack of global diversification cannot be explained by capital constraints. The only explanation is that investors in each country believe that their domestic market provides the best/safest investment opportunities. Investors in all five countries were taking the unnecessary risk of having “all their eggs” in their domestic basket, without any rational reason for doing so. It is simply a behavioral issue.
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A study found that the expected real return to U.S. equities was 5.5% in the eyes of U.S. investors, but only 3.1% and 4.4% in the eyes of Japanese and British investors, respectively. Similarly, expected returns on Japanese equities was 6.6% in the eyes of Japanese investors, but only 3.2% and 3.8% in the eyes of U.S. and British investors, respectively.3 Familiarity breeds overconfidence, or an illusion of safety, and lack of familiarity breeds a perception of high risk.

Many investors avoid adding international investments to their portfolios because they believe international investing is too risky. Academics, however, recommend that investors add international assets to their portfolios because they actually reduce risk. International equities do not move in perfect tandem with domestic equities. Therefore, the addition of international stocks to a portfolio should reduce the volatility (risk) of the overall portfolio. A study published issue of the Journal of Investing sought to determine whether international equity diversification actually provided that theoretical risk reduction benefit.

 

The study by David Laster examined the performance of portfolios with varying allocations to the S & P 500 Index and the EAFE Index. The study looked at portfolios with allocations of 10% S & P 500 and 90% EAFE, 20% S & P 500 and 80% EAFE, and so on. At the end of each year each portfolio was rebalanced (correcting for market movements) to its original allocations. Using a statistical method called “bootstrapping” (creating a series of monthly returns using randomly selected subperiods from the entire period), the study was able to effectively examine far more 5-year holding periods than its 27-year period contained. Before reviewing the results of the study it is important to note that during this period the S & P 500 Index outperformed the EAFE Index by 12.29% to 12.03% per annum. In addition, the correlation of returns between the two indices was 0.48, a fairly low figure.

 

The study concluded that:
  • A combination of the S & P 500 Index and the EAFE Index outperformed either index individually-a result of the low correlation.
  • Increasing the international allocation to as much as 40% increased returns and reduced risk as measured by standard deviation (volatility).
  • An allocation of 40% international produced the highest Sharpe ratio-a measure of the amount of return for a given level of risk.
  • Increasing the international allocation from 0% to just 20% reduced the likelihood of negative returns by one-third.
  • Investors with a 10% international allocation could be 98% certain that they would reduce risk by raising the international allocation.
  • Investors with even a 22% allocation could be 90% certain that they would reduce risk by raising their international allocation.

What is likely to surprise most investors is that adding international assets to a portfolio during a period when they underperformed actually resulted in higher returns and lower risk.

Perhaps the most common argument I hear against international investing is that the regulatory environment created by the SEC makes the U.S. a safer place to invest. I fully agree that this is true. However, before believing that you can benefit from this information you must ask yourself if you are the only one that knows it. Obviously, the market is aware of, and security prices around the world surely reflect, this information. 

 

Here is something else to think about. Perhaps one of the contributing factors to the strong returns U.S. stocks have provided over the last 50 years is the improvement that the SEC has made in its oversight of the U.S. capital markets. It seems logical to conclude that this improvement has contributed to the lowering of the perception investors have of the risks of equity investing in the United States. The result was a lowering of the risk premium investors demand. That resulted in a one-time capital gain, and lower future expected returns (reflecting the now lower perceived risk). Now applying that to foreign stocks you might draw the following conclusions. The market knows that foreign stocks are riskier because of the more lax regulatory environment. The market therefore prices for that risk and you get higher expected returns as compensation. Let’s now speculate on the following possible, if not likely, scenario.

 

The world has learned much about economic growth over the past 50 years as capitalism has triumphed. In order to grow their economies countries need access to capital. If a country does not have good disclosure laws, investors simply won't provide capital. Therefore, I think it is logical to conclude that the rest of the world will be moving to replicate U.S. regulatory standards. In fact, many foreign companies are already adopting U.S. accounting standards, as they want access to the U.S. capital markets. As more international companies and foreign markets adopt U.S. regulatory standards the risk premiums demanded for international stocks might fall as investors recognize the change and lower their required risk premium. Investors in international stocks would then realize a capital gain from the fall in the risk premium.

 

Let’s assume that you believe that the U.S. is safer (keeping in mind that investors in other countries also appear to believe that their domestic market is safer) because the economic and/or political prospects are better in the U.S. You should then conclude that the U.S. has lower expected returns. This would not mean that the U.S. was a poor place to invest. However, it is illogical to believe that the U.S. is a safer place to invest, while also believing that the U.S. will provide higher returns. Risk and expected reward should be related.

 

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INVESTORS INTELLECTUAL CAPITAL

There are other arguments for including international asset classes in a portfolio. U.S. investors have all of their intellectual capital in the domestic market. Their ability to generate income from employment is tied to U.S. economic conditions. They also might own a home, which may constitute a large percent of their assets. If the dollar falls in value on the currency markets, not only will the cost of imports rise, but the competitive pressures from cheap imports will also decrease, allowing domestic manufacturers to raise prices. This combination of events will lower living standards. Owning foreign assets acts as a hedge against this risk. 

Allocating a significant portion of your portfolio to international asset classes will provide an insurance policy against potential problems in the U.S. Since we don’t have a clear crystal ball, diversification of risk is an important element of the winning strategy. If you need any more evidence of this just think about Japanese investors in 1989. Like U.S. investors in 2000, they may have seen no reason to diversify internationally. Their economy was king. Their technology was dominating the world. Their managed capitalism system was clearly superior to our more market oriented system. And, the Japanese stock market had far outperformed the U.S. and other global markets for 20 years. As we ended 2000, the Nikkei Index was still down approximately 70% from its level of over 11 years ago. Those who do not learn from history are doomed to repeat the same mistakes.

 

Investing in international equities surely involves risk, but so does investing in domestic equities. And, the evidence suggests that including international equities within a portfolio reduces the overall risks of the entire portfolio.

 


Sources:
1. Gus Huberman, Familiarity Breeds Investment, September .
2. Kenneth R. French and James M. Poterba, “International Diversification and International Equity Markets,” American Economic Review, vol. 81, No. 2, pp. 222226.
3.Gus Huberman, Familiarity Breeds Investment II.

 

Larry Swedroe is the author of The Only Guide To A Winning Investment Strategy You Will Ever Need and What Wall Street Doesn't Want You To Know, available at amazon.com. He is also the Director of Research for and a Principal of Buckingham Asset Management, Inc. in St. Louis, Missouri.

Investors Confuse The Familiar With The Safe. Article By Larry Swedroe Inc.

 

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Seeking safer investments can lead you to confuse the familiar with the safe! Research investment choices. Keep up to date, speculate, diversificate and accumulate.

 

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