The Perils Of Investing Too Close To Home

Not long ago, the investment world was startled by stark evidence that do-it-yourself investors are terrible traders. Terry Odean, then a grad student at the University of California at Berkeley, unveiled his study of trading in 10,000 discount-brokerage accounts from 1987 to 1993. The stocks these investors sold beat the market, he found, while those they bought did worse (table). One year after the trades, the average investor wound up more than 9% poorer than if had he done nothing. Two years later, the results were even worse.

Does that outcome strike uncomfortably close to your portfolio? If you suspect so, you might benefit from the conclusions of a related study of investor behavior, recently released by Gur Huberman, a finance professor at Columbia University.

GOING LOCAL. Odean's work suggests that do-it-yourselfers, expecting they'll profit more by making trades than standing pat, are overconfident. Now, Huberman's study points out that one form of this crippling overconfidence may be investors' predilection for shares in familiar companies.

Huberman started by wondering why global investors so clearly prefer domestic over foreign stocks. Did this "home country bias" stem from such barriers as foreign exchange and capital controls? Or did it, as he surmised, have more to do with investors' psychological need to feel comfortable with where they put their money?

Huberman tested his hunch by examining stock-ownership records of the seven regional Bell operating companies (RBOCs). He found that in all but one state, more people hold shares of the local RBOC than any other, and their holdings average $14,400. For RBOC investors who don't stick with the local unit, the average is $8,246.

Plainly, all of those investors can't be right. Everyone's local RBOC can't be a better investment choice than any of the other six. Yet, as Huberman observes, "people delude themselves into thinking that they know more than they do."

Odean, now a finance professor at the University of California at Davis, thinks individual investors impose a variety of filters to sift through the field of 10,000 or more U.S. stocks. Some filters, such as a below-market price-earnings ratio, may be rational. Others--"I'm not going to buy a stock I've never heard of"--aren't.

If you systematically favor familiar companies, you're probably overestimating the superiority of your information. Chicagoans, for example, may think they're smarter about Ameritech than about Bell Atlantic, while folks in Philly think they know more about Bell Atlantic than Ameritech. Yet even though you're familiar with a stock, you should be as willing to reject it as accept it. Huberman's study found that local investors everywhere but Montana overwhelmingly preferred their RBOC. "The crux of the matter is, how much do you know about what you know?" Odean says.

To embrace the familiar makes sense for those who swallowed glib accounts of such stock-picking stars as Fidelity Investments' Peter Lynch and Berkshire Hathaway's Warren Buffett. It's often pointed out that Lynch's taste for Dunkin' Donuts coffee led him to a winning investment in the company, and Buffett's thirst for Cherry Cokes helped him toward his big score in Coca-Cola shares.

To be fair to both men, their own detailed accounts also emphasize the necessity of figuring out a company's cash flows and whether its stock is cheap next to the current value of those cash flows. Trouble is, how many do-it-yourselfers are sharp estimators of future cash flows? "It takes a few more steps between saying, `This is a good company,' and saying `The price is low,"' Huberman cautions. "The danger is most of us stop at the first step."

Huberman concludes that when investors tilt toward familiar stocks, they take on more risk by diversifying less broadly and also by investing with the herd--thereby cutting potential returns. "If people are more willing to buy the familiar," Odean notes, "there is going to be a premium on the price."

USUAL SUSPECTS. Besides telephone companies, what other stocks might be dangerously familiar? For starters, your employer's stock. Huberman cites recent surveys showing employer stock makes up one-third or more of total 401(k) assets. You also might hesitate over any impulse toward buying "affinity" stocks--Apple Computer if you're a Mac user, say, or Berkshire Hathaway if you're a Buffett admirer. It's not that either stock necessarily is overvalued. You just might be kidding yourself on how well you understand the company's prospects.

Besides moving past the familiar, Huberman thinks "people should diversify internationally, even though they consider themselves completely ignorant about France and Germany and wherever." In his thinking, the best approach is through mutual funds, particularly index funds.

As for persistent stock-pickers who get a charge out of trading and can't bear settling for an index fund? Odean's advice: "Cool out on your trading."

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