CBS Money Watch
March 23, 2012
Original article by:Larry Swedroe
We’ve all been there. We have a gut feeling about our favourite company. We think because we love their products or their press that we really know the company, almost as an insider. How could we go wrong? If we love the company, many others must as well. Seems like a sure thing. So, we go ahead an invest in their stock. Or, as Larry Swedroe discusses here, we work in an industry sector and we feel we know the market, the competition and all the upsides (and downsides). Who could know better than us what the future would bring. So we make what we see as a sure investment in our sector.
Investing in the same
industry as your occupation hasn't yielded better results for
investors. (Image courtesy of Flickr user Phillie Casablanca)
Peter Lynch was one of the
most successful mutual fund managers we've seen. One of his strongest pieces of
advice was to buy what you know. In fact, the title of one of his books was
"One Up on Wall
Street: How to Use What You Already Know to Make Money in the Market." But is this
actually good advice? The authors of the recent study, "Do Individual
Investors Have Asymmetric Information Based on Work Experience?," put this theory to
the test.
The goal of the study was
to see if individual investors preferred "professionally close"
stocks (meaning stocks of companies in fields related to their profession) and
if they could outperform a benchmark essentially by buying what they know. The
study also looked at the performance of investors buying stock of the companies
they work for, as well as other companies near where they live. The following
is a summary of their findings:
- Individuals failed to diversify their human capital, overweighting stocks in their industry of employment.
- Individuals didn't earn abnormal returns when trading professionally close stocks. On a one-year level, a portfolio of stocks related to investors' areas of expertise had a negative alpha of about 5 percent (meaning investors performed worse than the benchmark). Also, the stocks they sold outperformed the stocks they bought by about 4 percent annually.
- Individuals traded excessively in professionally close stocks, showing that investors felt more confident trading stocks of companies they knew.
- Advanced degrees didn't provide any benefit. Those with a Ph.D. didn't generate abnormal returns.
- Local proximity provided no advantage.
The authors concluded:
"Our findings are consistent with both familiarity and overconfidence
being the behavioral driver behind our results."
When we are dealing with money, we know that we are
dealing with a complex mix of emotions.
Money is our life, it’s our past and it’s our future. How can we expect ourselves not to be
emotional when so much is riding on this one variable. Money represents all our hopes and
fears. Money can provide us with the
future we always dreamed of or it can lead us down a path of ruin. We know that people are often overly
confident about their investing acumen.
Many studies have shown that when investors are asked about their
investing skill, they often over-estimate their success rate. Yet, when we look
at actual returns, they never measure up to the belief that investors have
about how well they perform. This is why
a financial professional is so important when making critical investment
decisions. A professional has the
advantage of objectivity and brings a much need rational mind to the process.
Peter Lynch advocated
buying what you know. And research into human behavior demonstrates that people
prefer to bet in a context where they consider themselves knowledgeable or
competent rather than in a context where they feel ignorant or uninformed.
Unfortunately, as Gary Belsky and Thomas Gilovich, the authors of "Why Smart
People Make Big Money Mistakes," noted: "For every example of a
person who made money on an investment because she used a company's product or
understood its strategy, we can give you five instances where such knowledge
was insufficient to justify the investment." The results shown above
demonstrate that Belsky and Gilovich got it right.
The findings from this new
study provide clear evidence of behavioral biases in the investment choices of
individuals and add to a large body of evidence demonstrating the general
tendency of investors to hold stocks of their employers and other companies
they feel they know. Unfortunately, this goes against one of the principles of
portfolio theory -- diversification is the only free lunch in investing, so you
might as well eat a lot of it. Keep these findings in mind the next time you're
tempted to invest in what you think you know.
Remember, you are often not aware of your emotional
connection to your money and your investment decisions. It makes great sense to consult with a
professional, if only for a second opinion. That move could make a difference
between financial success and financial failure.
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