What I Know Is Better
ONE-YEAR AND FIVE-YEAR RETURNS FOR GLAMOR AND VALUE STOCKS.
Figure 11.1 11.4% 18.7% 12.3% 16.2% 81.8% 143.4% 71.7% 138.8% 0.0% 20.0% 40.0% 60.0% 80.0% 100.0% 120.0% 140.0% 160.0%
Glamor (High Sales Growth)
Value (Low Sales Growth)
Glamor (High P/E Ratio)
Value (Low P/E Ratio)
Return
1-Year Return 5-Year Return
has increased sales by more than 20% per year in the past couple of years and has increased earnings per share by over 35% in each of the past two years. This well-known growth company is no small business—it’s Compaq Computer Corp. For the year 2000, Compaq had over $24 billion in revenue and nearly $2 billion in profits. In late 1998 Compaq sounded very glamorous. Indeed, during the three years prior to 1998 the firm’s stock had risen 338%. In January of 1999, Compaq stock rose 17% more to $49.25 a share. That was the peak for Compaq. One month later the price was $35 a share. Three months later it was $24. The price eventually fell to less than $20 a share. All this in 1999, the year that may have been the best ever for technology firms.
Good companies do not always make good investments! Investors make the mistake of believing they do because they believe that the past operating performance of a company is representative of its future performance and they ignore information that does not fit into this notion. Good companies do not perform well forever, just as bad companies do not perform poorly forever.
You can make a similar error when examining past stock returns. For example, a stock that has performed badly for the past three to five years is considered a loser. Stocks that have done well for the past three to five years are winners. You may consider this past return to be representative of what you can expect in the future. In general, investors like to chase the winners and buy stocks that have trended upwards in price. However, the losers tend to outperform the win- ners over the next three years by 30%!3Mutual fund investors also make this error. The mutual funds listed in magazines and newspa- pers with the highest recent performance experience a flood of new investors. These investors are chasing the winners.
In short, you interpret the past business operations of a com- pany and the past performance of its stock as representative of future expectations. Unfortunately, businesses tend to revert to the mean over the long term. Fast-growing firms find that competition increases, slowing their rate of growth. Disappointed, you find that the stock does not perform as expected.
FAMILIARITY
People prefer things that are familiar to them. They root for the local sports teams. They like to own stock in the companies they work for.
Their sports teams and employers are familiar to them.
When you are faced with two risky choices, one of which you have some knowledge about and the other of which you have none, you choose the one you know something about. Given two differ- ent gambles where the odds of winning are the same, you pick the gamble that you have more experience with. In fact, you will some- times pick the more familiar gamble even if its odds of winning are lower.
Familiarity Breeds Investment4
There are tens of thousands of potential stock and bond investments in the United States. There are also that many choices overseas. So how do investors choose? Do you analyze the expected return and risk of each investment? No, you trade in the securities with which you are familiar. There is comfort in having your money invested in a business that is visible to you.
As an example, consider the breakup of AT&T. In 1984 the gov- ernment broke up AT&T’s local phone service monopoly into seven regional phone companies known as the baby bells. Twelve years after the breakup, who owns these baby bells? It turns out that investors are more likely to own shares in their local phone company than the phone company of another region—they are more com- fortable investing in the more familiar company.
The inclination to invest in the familiar causes you to invest far more money inside the borders of your own country than tradi- tional ideas of diversification would recommend. In short, you have a home bias because companies from your own country are more familiar to you than foreign companies.
Figure 11.2 illustrates the home bias.5The stock market in the United States represents 47.8% of the value of all stocks worldwide. The stock markets in Japan and the United Kingdom represent 26.5% and 13.8%, respectively, of the worldwide stock market. Therefore, to fully diversify a stock portfolio, you should allocate 47.8% of your portfolio to U.S. stocks, 26.5% to Japanese stocks, and 13.8% to U.K. stocks. In fact, modern portfolio theory suggests all investors should have this allocation! But do investors use this allocation? The answer is a resounding no. The stock portfolios of U.S. investors are 93% invested in U.S. stocks, not the 47.8% sug- gested by portfolio theory. Japanese investors are 98% invested in Japanese stocks. U.K. investors have 82% of their stock portfolios in
INVESTMENT MADNESS:How psychology affects your investing…and what to do about it 117
U.K. stocks. Investors purchase the stocks of companies that are familiar to them, and people are simply less familiar with foreign firms.
People invest some, but not much, money in foreign companies. What types of foreign stocks would you buy? Those that are familiar to you. The foreign companies that are most familiar are the large corporations with recognizable products. For example, non- Japanese investors tend to own the large Japanese companies.6The smaller Japanese firms that attract non-Japanese investors have high levels of exports. Investors choose stocks that are familiar to them in both domestic and foreign markets.
Americans pick familiar foreign firms, but they bias their portfo- lios toward U.S. companies. They also tilt their portfolios toward local firms. For example, Coca-Cola’s headquarters is located in Atlanta, Georgia. Investors living in Georgia own 16% of Coke,7and most of these investors live in Atlanta. Coke sells its products world- wide, but the people most familiar with the company own a large percentage of it.
Professional money managers also invest in the familiar. Even though U.S. professional investors have access to vast information sources and analysis tools, they still tilt their portfolios toward local firms. This is especially true for small local firms and riskier firms.
118 WHAT I KNOW IS BETTERchapter 11
DOMESTIC COUNTRY’S PROPORTION OF THE WORLDWIDE