Why we stay home and why it's a bad idea
It's human nature to feel at ease with what's familiar. But in investing, comfort can cost you a lot of money.
(Money Magazine) -- A friend of mine whom I will call Vijay is one of the most normal investors I know. A software engineer, Vijay has stock options in his company that (on paper, at least) made him a millionaire in the late 1990s, a pauper in 2001 and solidly upper middle class today.
He keeps 70% of his 401(k) stashed in his company's stock. Outside his 401(k), Vijay's biggest holding is a mutual fund that specializes in technology stocks. The second-biggest is a handful of stocks based in India, where his family is from.
So Vijay was taken aback when, the last time he bragged to me about how much money he had made, I calculated how much better he could have done if he'd had a more diversified portfolio.
By my math he would be at least 40% wealthier today if he had taken all the money he invested in his company and industry and instead put it into an index fund that invests in the U.S. stock market as a whole. He's made a bundle on his India stocks, true, but in that volatile market he could lose a bundle tomorrow. In any case his gains there aren't enough to make up for the huge losses he suffered when tech stocks tumbled in 2000.
What makes Vijay so normal is that he does not dispute my math, nor even disagree with my advice. But he hasn't taken it either. "It just wouldn't feel right to me not to invest in what I know best," he says.
Does he sound like anybody you know?
There's no place like home
Vijay suffers from what psychologists call home bias - the automatic and almost universal preference for whatever feels familiar. At 401(k) plans that offer company stock, 24% of all investors choose to keep at least half of their retirement money in their employer's shares.
The typical U.S. investor keeps 87% of assets in domestic stocks, even though the U.S. makes up only about 50% of the total value of the world's markets.
This isn't solely an American phenomenon. Greeks, whose stock market accounts for 1% of the world's capitalization, keep 75% of their money at home.
Meanwhile, the "experts" stick close to the familiar too. Professional money managers strongly favor companies based nearer to the investment firms' offices. Corporate pension plans tend to hire money managers with headquarters not far from their own.
What drives this behavior? Special neurons in your brain called "place cells" fire in the presence of the familiar, imparting a warm glow to what you already know.
Have you ever noticed that it seems to take more time to drive somewhere you've never been than it does to drive back? That's because a single ride on the route is all it takes to raise your comfort level.
If you are shown a geometric shape for a thousandth of a second ( 1/300 the duration of a blink of the human eye, far too fast to register in your conscious mind), you will like it better the next time you see it, even though you'll have no idea you've seen it before. Whatever is familiar is more comfortable and makes you feel more confident that you understand it (even if you don't know as much about it as you think).
In addition, when you consider investing in the unfamiliar, a fear response is triggered. At the University of Münster in Germany, neuroscientist Peter Kenning found that when people considered buying a mutual fund that invested overseas, an alarm went off inside the amygdala, a structure that functions as one of the fear centers in the brain.
No wonder that in many people's minds, investing in something unfamiliar feels much like being lost on the wrong side of town at night.
Yet none of this means that familiarity is nearly as good as it feels. As I reminded Vijay, his company's stock lost 90% of its value in 20 months between 2000 and 2002, and India's market has gotten rocked repeatedly. I asked him whether his familiarity with these assets that he "knows best" had enabled him to predict any of those losses.
After a painful pause, he said no.
The truth is, knowing a lot about your company does not mean you know a lot about what the stock is going to do in the future; ask someone who worked at WorldCom.
The same is true for the country you live in. No one knows more about Japan than the Japanese, and they kept 98% of their money in Japanese stocks back in 1989 - right before the Tokyo exchange went into one of the worst declines in history.
How can you stop being such a homebody? First, remember that if you keep most of your money in your own company, you will miss out on lots of others that could give you almost as warm a glow, from Apple to Wyeth.
If you invest entirely in the U.S., you rule out two-thirds of the world's publicly traded companies.
Next, remind yourself that investing is not simply about being sure you are right but about making sure you are protected if you turn out to be wrong. Your own company (and even this country) may not always be as lucrative as it has been lately. Therefore, you need to own U.S. stocks in every industry, not just yours, and stocks around the world, not just here.
Keep no more than 10% of your stock portfolio in your own company's shares (and less is better, frankly) and at least 20% outside the U.S. Some bonds and cash are a good idea too.
From the July 1, 2007 issue