Do You Only Invest In Investments You ‘Know’?
We all like the comfort of familiarity. When we’re faced with choices and we know more about one option than the other, our minds lead us to select the more familiar option.
21 October 2021
Usually, this is a smart idea. But not with money.
Because of our tendency to favour the familiar, we’re likely to root for our local sports teams, or invest in a company we find familiar, even if they’re a bad choice.
In investing, that’s because when we’re faced with so many possible choices in shares and bonds here and offshore, that otherwise we just can’t choose?
Rather than analysing the risk and return of our potential investments, we invest in the companies or government shares we’re familiar with.
In fact, a recent study analysing this phenomenon clearly shows that investors don’t follow modern portfolio theory. Because if they did, they’d own more foreign shares, rather than relying on so many stocks from the local share market.
Even the experts do it
When we do invest in foreign companies, what do we normally buy? Yes, you guessed it: familiar foreign firms, that is big companies with products we recognise.
Interestingly, it’s not just you that does this. The same bias is found in fund managers. Those from continental Europe predict that their domestic share market will perform better than those of the UK, the US and Japan.
At the same time, managers in the UK predict their domestic returns will be highest. They’re overly confident and optimistic about the shares that are familiar to them, and too pessimistic about the equities they’re not familiar with.
The Coca-Cola conundrum
Take the example of world-famous US company, Coca-Cola, which has its headquarters in Atlanta, Georgia.
Investors living in Georgia own 16 per cent of Coca-Cola and, furthermore, most of those investors live in the city of Atlanta. Coke sells its products worldwide, but the people most familiar with the company own the largest percentage of it.
By now, you’ll be aware that when you’re familiar with something, you have a distorted perception of it. Fans of the All Blacks, for example, think they have a higher chance of winning than any opposition team.
The reason we like familiarity when we invest is simple.
There are limits to the amount of information we can process at one time – it’s difficult to rank hundreds of options, let alone the thousands available. So, we reduce the options we consider by only looking at those we are familiar with; depending on our preferences.
What do you do?
Do you do this? Do you invest only in investments you ‘know’?
You should invest in companies or funds that are the best performers, rather than opting for the simplest ‘on the face of it’ analysis.
Otherwise, you’ll always think the All Blacks will win.
First published 14 February 2019
Story by Sheryl Sutherland
This article is part of the Rational Investor series by Sheryl Sutherland. Sutherland, of the Financial Strategies Group, is an investment adviser who has worked in the industry for the past 30 years. She’s also the author of multiple best-selling books.
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