“Familiarity Breeds Investment” Huberman (2001)
Investors’ inability to sufficiently diversify their portfolios is one of the major errors in behavioural finance. Investors tend to place too much of their funds with companies they know, in the country they live in, and most damagingly of all, with the companies they work for. Diversification is at the heart of modern finance theory: investing your funds in a variety of assets produces a portfolio that is less risky than the sum of its parts. Why do investors make this mistake?
This paper looks at the pattern of holdings of the seven telephone companies formed from the divestiture of AT&T. In almost every State of the US investors place more of their funds with their local telephone company than any of the others. This is interesting as it runs exactly counter to the logic of diversification. It is not how risky an asset is that is important, but how much risk it adds to the portfolio of all your investments. And this is based primarily on the correlation between that asset and others. Assets that are individually risky, but are subject to unique sources of risk, can actually reduce the risk level of the portfolio. This means that you should tend to underinvest in assets from your country and local area, as these assets are most closely linked with your future labour income.
So why do investors commit the diversification error? Huberman argues that familiarity is the common explanation. This rules out the one possible rational explanation: that investors are exploiting information advantages. For example, almost all the telephone companies are most popular with their regional investors. There’s no way that every single one of them could outperform a composite portfolio of all of them. Ambiguity aversion is one common finding from decision theory: we prefer to take known risks than unknown gambles. Stocks that we know feel like less of a risk, even if we hold no unique insight. While this is surely a large part of the story, I don’t think it explains the whole phenomenon. And let’s not forget that in many real-world contexts going with what you know well is the right decision.
Diversification is a hard concept to understand, with few real life analogues. Although a football team requires a group of players with different skills to function successfully, it can be hard to grasp why we shouldn’t “Put all your eggs in one basket and watch that basket!” I believe that part of the reason for this failure is that people naturally make one financial decision at a time, failing to see how the sum total should be integrated.** At the end of each month we might consider how to invest our spare cash. In each instance, investing it in company stock might seem like a good idea. If investors, however, were forced to invest their entire portfolio in one instance, I have a feeling that they would spread their cash around a lot more. And in fact this is a finding from consumer psychology, amusingly for this instance labelled “diversification bias”. With this diversification bias individuals fail to understand how their consumption tastes might vary through time, and so seek more diversification than their future selves might want. When buying chocolate bars for the next week you might buy a few of our favourite type but also some less tasty chocolates, when in fact your consuming self on each day might prefer only to eat your favourite.
So a couple of interventions to reduce the investment diversification bias might be to help individuals integrate decisions into the rest of their portfolio, and to create an overall investment plan at a point in time to guide future decisions (perhaps automatising future investments subject to this plan). I suspect that helping investors to taken on a portfolio frame would reduce the incidence of many of the errors in behavioural finance.
** This is the case with most consumer decisions: the restaurant you went to last month, beyond the information you received on its quality, should not affect the restaurant you go to today. Diminishing marginal utility is the only reason to “diversify” your consumption, and it isn’t a major concern with many decisions.