Home Country Bias and Investing in What You Know

I was talking to someone very recently about general business topics, and and we ended up briefly delving into a discussion on international markets. As a part of this discussion, I mentioned that I have been wanting to increase my exposure to non-US markets, but am currently well under 10%.  My comments were that I thought I need to revisit this ratio.

The guy with whom I was talking paused for a second, furrowed his eyebrows, and then stated that he didn’t believe he had any direct international investment. He went on to comment that he’s fine with that, because how was he “supposed to know what consumers in China want?” He used China as a proxy for any market distant from the U.S. Essentially, he was saying that he didn’t understand foreign markets, so why invest in them? Right away, it seemed to me like he had a home country bias.

There’s an old maxim that you should “invest in what you know”. It’s a general philosophy that was a big part of Peter Lynch’s teachings. Lynch is probably best known for being the acclaimed manager of the Fidelity Magellan fund, as well as for authoring several popular investment books.  Lynch has probably forgotten much more about investing than many of us will ever know. In other words, he knowledgeable. Clearly, Lynch achieved quite a bit of success, so there’s obviously something to the the application of this principle of investing in what you know. Furthermore, he’s just an example to point to – there are scores of investors who take this approach. Yes, just like the guy with whom I was having the aforementioned discussion.

Now, I might not be someone to dispute this approach….but then again, I’ll do it anyway:)

My view on the idea of sticking to what you know is that it has merit, but it can be misapplied and taken too far.

If somebody asks me to make a big investment in a bauxite mining operation, as an example, I’d pass. Now, it just might be a great opportunity, but since I know absolutely nothing about that business, I wouldn’t make such an investment. In that case, I’d stick to what I now, or at least avoid what I don’t know.

However, there are other legitimate examples of when it’s good to ignore the “buy what you know” approach:

  1. Mutual Funds. If somebody asks me to make small investments across a representative set of companies traded in the stock market, I’ll think about it. Why? Well, isn’t that what index funds are, more or less? I might not know a lot about these companies, but I know enough to say that historically, stocks have earned a rate of return that well outpaces inflation.  That’s enough to get me to buy stocks in a ton of different companies, all through an index funds. Index funds are a great example of how taking the “invest in what you know” approach can go too far. If you follow that approach too closely, you’d miss out on all the advantages of investing in funds.  Including funds that hold positions in companies that you know nothing about.
  2. Investing in a Company other than Your Employer.  I’ve heard of several people who simply wanted to invest in the stock of their employer, because it’s what they know (or so they think). In post from the early days of the blog, I shared the story about a guy who invested everything in the company stock. He told a large gathering at a retirement party that he invested everything in the company stock over the years and that it worked for him, so we should consider doing it too. Surprisingly, he got an ovation for that. Meanwhile, I sat quiet thinking that he was so totally wrong. Maybe he got lucky with his investments, but it’s very risky to put all of one’s eggs in one basket. You already have employment risk in a company, why add investment risk too
  3. Investing in International Stocks. This applies to the guy I mentioned above, who might want to at least consider diversification. A prior post I wrote a while ago discussed the topic of international stocks and diversification. In that post, I referenced another article which stated that at the time, the U.S. held 43% of global stock value, yet American investors hold 70% of their stock portfolios in American companies. Frankly, I’m surprised it’s that low! What’s also interesting is that the United States’ share of the world stock market value was 90% back in 1945, and has since declined to the 43% figure I mentioned above. This phenomenon of home country bias is not exclusive to the U.S. either, as it’s been seen in even more drastic terms in some other countries, as I noted in the prior post. Yes, it seems like we all need to realize that’s there’s a world out there!

My Questions for You:

Do you prefer to strictly invest in what you know, or do you branch out?

If you do branch out, do you follow each of the 3 approaches above?

Do you know anybody who carries a home country bias with investments?

 

Are Actively Managed Funds a Fool’s Game Compared to Index Funds?

When it comes to investing in stocks, some of us like to be highly active stock pickers. Others among us like to invest passively, even to the point of a “set it and forget it” strategy.

One example of active vs passive can actually be indirect, through mutual funds.  In this example, as many of us know, we aren’t exactly picking the investments in a fund. Rather, the fund manager is picking the investments. Sometimes, these funds can actively trade many stocks. So even though we buy into mutual funds at a price per share (based on the net asset value) similarly to how we do a stock, there can be tons of trades going on with our money even if we ourselves don’t sell anything. The fund manager is behind the scenes making the moves, making this an active strategy of sorts.

On the other hand, if we buy a mutual fund that’s simply index-based, there’s very little activity involved. An S&P 500 index fund, for example, is set up to mirror the performance of the actual index. The brain work is taken out of the process, and there isn’t a fund manager’s acumen influencing the performance of the fund. It’s all based on how the individual stocks in the fund perform.

This of course brings us to the established, oft-discussed topic of index funds vs. actively managed funds. Thinking about it based on what we’ve discussed above, we’re really choosing between:

  • Professional fund manager input into our investment; or
  • No professional input, just independent stock performance guiding our investment

On the surface, it just seems logical that all things being equal, a professionally managed fund should outperform one that’s not professional managed, right? We’re often told about the virtues of index funds, and passive investing, but shouldn’t there be value to having a professional guide the stock picking within a fund?

Well, maybe there isn’t always value to a a professional actively managing a fund.

An article I saw on Moneywatch further supports the case for index funds over actively managed funds. According to this article, data from Standard & Poors shows that active fund managers have been consistently outperformed by index-based benchmarks. This finding is across cap size and covers the last 3 years.

Here’s the extent of the disparity with these actively managed funds:

  • Large-Cap focus: 64% were outperformed by the S&P 500
  • Mid-Cap focus: 75.1% were outperformed by the S&P MidCap 400
  • Small-Cal focus: 63.1% were outperformed by the S&P SmallCap 600

Thus, for all the extra fees that are being paid, investors are getting nothing back. In fact, one could say that investors are getting punished for going with actively managed funds!

Now, there are some funds that clearly do outperform the market. However, the majority haven’t been doing so.

Personally, I’ve been a fan of index funds, but have a mix of index and actively managed funds.  At this point, it’s hitting home that maybe I should jettison the actively managed funds and replace them by adding additional investment in index funds?

I suspect that many people (including me, apparently), have previously found index fund investing to be “average” or lacking risk taking or a pursuit of wealth.  Who wants to be average, right?

Well, maybe average actually means winning in this case!

My Questions for You:

If you own mutual funds, do you focus on index funds?

What do you think about the notion that the pursuit of average, in terms of market returns, is actually a winning strategy in some ways?

Why do you think people pursue actively manage funds, despite the evidence that index funds outperform them?