Go global for a free lunch
A core investing lesson is that diversification is a good thing, perhaps even a
financial free lunch. As a guide to someone having a basic grasp of sensible
investment essentials, it’s right up there with knowing that investing is a
long-term pursuit and that past performance is no guarantee of future
performance.
While short-term crashes can correlate across countries, over the long run,
markets that live apart, die apart. 1 International diversification thus
protects long-term investors from the risk of a country going missing for a
decade or two - especially useful if that same country is also paying your
wages.
Yet across the world, both amateurs and professionals make a conscious
effort to ignore international diversification in portfolio construction, often
to a considerable degree.
International diversification thus protects long-term investors from the risk of a country going missing for a decade or two.
The answer – as ever where the technically ‘correct’ deviates from the
practically observed – is that people buy stories, not investments. Without a
supporting framework of fairytale-esque familiarity, diversification leads to
discomfort. Viewed from another angle, familiarity breeds unjustifiable
comfort: investors have an innate, and costly, preference for concentrated
portfolios of nice narratives, rather than diversified portfolios of good
investments.
Investors pick not the answer that keeps the textbook happy, but the one
that keeps themselves happy. That delivers not an impersonal theoretically
optimal risk-adjusted return, but a personal, and often costly, anxiety adjusted
return: they give up financial efficiency for emotional comfort. If
diversification causes distress, it ceases to be such an obviously smart idea.
A certain amount of home bias can be useful in buying emotional comfort at
relatively low cost, but most investors veer too much to the familiar, and pay
too much as a result.
Nothing to fear
From an abstract fear of the unknown, to peer-group regret avoidance, to
simple, but not necessarily pure, xenophobia, investors may derive comfort
from the devils they know in several ways.
While changes to investments could be called for – of all the deviations from
the ‘optimal’ portfolio, a limited amount of home bias is one of the better
ones – changes to the decision - making processes and communications that
surround the investments are a more cost-effective means to the same
ends. Even when deliberate home bias is a cost-effective source of
emotional comfort, it’s even more so when accompanied by narratives that
draw investor attention to the more naturally familiar components of a
portfolio. Because humans neglect scale in narratives, a story emphasising a
holding making up, say, 5% of a portfolio may provide comfort with 100% of
it.
Other examples include: encouraging phasing for acclimatising to foreign
assets; agreeing to govern decisions by pre-set rules, thus diminishing the
emotional pull of in-the-moment prejudices; bundling familiar and
unfamiliar assets together; and focusing reports on high - level stories rather
than individual component performances.
Knowing which solutions to adopt in which circumstances means knowing
the investor they’re being adopted by. Deviations are unnecessary if the
investor doesn’t care in the first place, and different sources of discomfort
call for different remedies. The key to this is profiling, which is why
Familiarity Preference is one element of Oxford Risk’s Financial Personality
Assessment.
A high preference for familiar investments can tailor not only the adviser-client
relationship, but also an investor’s education, for example, specific
training to become less attached to home-market benchmarks.
Knowing which solutions to adopt in which circumstances means knowing the investor they’re being adopted by.
Risk free
While the optimal ratio of home to overseas assets is unclear, skewing a portfolio on the grounds of geographic familiarity is unsupported... economically, at least.
Investors are humans, and as such are, in the words of J.G. Ballard,
‘Desperate for the new, but disappointed with anything but the familiar’.
When moving into the new world of investments, it’s important not to
confuse familiarity with safety (it can be the reverse!) nor to blindly adopt
unnecessarily expensive solutions to problems that lie more with
perceptions than portfolios.
1 Asness, C., (2010). International Diversification Works (Eventually).
Financial Analysts Journal, Volume 67
About the author
Greg B Davies, PhD
Greg is a specialist in applied behavioural finance, decision science, impact investing, and financial wellbeing.
He founded the banking world’s first behavioural finance team at Barclays in
2006, which he led for a decade.
In 2017 he joined Oxford Risk to lead the development of behavioural
decision support software to help people make the best possible financial
decisions.
Greg holds a PhD in Behavioural Decision Theory from Cambridge; has held
academic affiliations at UCL, Imperial College, and Oxford; and is author of
Behavioral Investment Management.
Greg is also Chair of Sound and Music, the UK’s national charity for new
music, and the creator of Open Outcry, a ‘reality opera’ premiered in London
in 2012, creating live performance from a functioning trading floor.
Follow Greg B Davies on Twitter
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