Human Foibles and Investment Decision Making
Dangerous influence of intuitive impressions
Many investors feel more comfortable investing in stocks from their home state, province or region. Many limit their investing to their home country. We can develop an illusion that it is somehow safer to invest close to home. This is the ‘home bias’.
Many investors have a bias towards investing in companies that are ‘household names’. They are familiar with the companies. They are conventional. Everyone knows the companies. That might be fine if the companies were fine investments. Call it the ‘household name bias’.
The problem is that these investments may have been made without the investor ever turning their mind to the true investment merits of the company.
Decisions based on intuitive impressions
These biases are part of a family of biases that bedevil investors. They include things like investing in the company because we like the product; Investing because we think solar power is good for the planet; investing because an uncle has shares in the company; and so on.
Daniel Kahneman asks: Have you ever realized that many of your “judgments and decisions are guided directly by feelings of liking and disliking, with little deliberation or reasoning.” (Kahneman, Thinking Fast and Slow, 2011) p.12.
In 1979, Kahneman and his colleague Amos Tversky, published a paper titled “Prospect Theory: An analysis of Decisions under Risk.” He was awarded the 2002 Nobel Memorial Prize in Economic Sciences. Kahneman’s field is called Decision Theory.
His work has been focused on the pervasive influence of intuitive impressions on our thoughts and our choices. Decisions made based on our liking, disliking, comfort, lack of comfort or our initial impressions are made based on what Kahneman calls ‘cognitive ease’. The shortcut we take is called a heuristic. In this case it is the Affect Heuristic.
Kahneman tells us that the shortcut “sometimes works fairly well and sometimes leads to serious errors.” (Kahneman, 2011) p.98.
The solution to the problems caused by these biases is easier to describe than act on. I can say: “Be aware we are predisposed to invest in our home country.” I can add: “Be aware doing so can lead to sub-par investments”.
“Be aware we are predisposed to invest in the familiar”. “Be aware doing so can lead to sub-par investments.”
Let’s go a little further. I can write about this because I’ve made those mistakes and hopefully learned from them. At the end of 2002 about 95% of our family’s investments were in Canadian common stocks and about 5% in U.S. stocks. I had never heard of ‘home bias’ nor had I heard of Daniel Kahneman. As best I can recall, my thinking was that I was planning to retire in Canada and thus it made sense that almost all of our investments should be in Canada and denominated in Canadian dollars. Canada is a developed country with many substantial companies and a well-regulated stock market.
Later, I must have read somewhere about home bias. I came to realize I had been missing out on all sorts of wonderful investment opportunities. Within a few years I added to my U.S. stocks and also took advantage of American Deposit Receipts (ADRs) to buy shares of companies based in Germany, the U.K., France, Israel and China. My non-U.S. investments were held in an ordinary investment account (not tax advantaged) so that I could deduct taxes withheld by the different countries on dividends from my Canadian taxes. For Canadians, the best place to hold U.S. stocks is in our tax advantaged Registered Retirement Savings Plans because the Canada/U.S. tax treaty provides that no taxes are withheld on U.S. dividends paid into those accounts.
As time went by I dumped all my non-U.S. international stocks for poor performance. I also had a tousle with the German tax authorities because they were withholding taxes above the treaty rate.
My current portfolio mix is Canadian Equities 45.6% and US Equities 52.39% and nil other international. I keep an eye open for promising international (non U.S.) companies. My current mix reflects, very simply, that the U.S. market has some of the best companies in the world. It is also well regulated. The Canadian stock market is heavily weighted to banks, telecoms, energy, a couple of big railway companies and materials. Many Canadian companies are of the household name variety and as comfortable as old slippers. They exist in oligopolies. They have already carved up the Canadian market and make a pretense of competing for each other’s customers. They typically have little room to reinvest their profits at very attractive rates of return. They have to make major investments in their businesses to stay competitive and stay in the same place.
There are a number of Canadian companies that operate in a more dynamic environment. They often operate worldwide. They generate excellent free cash flow and have opportunities to invest for profitable growth. Those are the ones I am interested in and own.
U.S. investors probably don’t think too much about currency swings; They should.
Kindleberger reports: “The sharp depreciation of the U.S. dollar in the late 1970s was much greater than the decline that would have been forecast on the excess of the U.S. inflation rate over the inflation rates in Germany and in Japan. Then in the early 1980s the U.S. dollar appreciated by 60 percent even though U.S. inflation remained higher than the inflation rate in Germany.” (Kindleberger, Manias, Panics, and Crashes, A History of Financial Crises. 1978, 2005 Fifth Edition) p.279.
It is not only the currencies of developing countries that can fluctuate wildly.
Kindleberger notes that: “The Finnish marka, Swedish krona, British pound, Italian lira and other European currencies lost 30 percent of their values relative to the German mark in the autumn of 1992 when the European Exchange Rate Mechanism broke up.” (Kindleberger, 1978, 2005 Fifth Edition) p.279.
Currencies and U.S. companies.
S&P 500 companies generate almost half their sales outside the U.S. When the U.S. dollar is strong U.S. export sales sag. As well, when the U.S. dollar is strong, foreign earnings translated back into U.S. dollars also sag, a double whammy. The amounts for foreign sales and earnings are generally available for individual companies in their quarterly and annual reports. Many companies report on the sensitivity of their sales and earnings to changes in exchange rates.
When the U.S. dollar is strong against foreign currencies, American companies that use inputs like raw materials, energy and other products that are priced internationally in U.S. dollars benefit from reduced input costs. The price of resources such as oil and copper tend to go down when the U.S. dollar is strong. As well, U.S. companies with global supply chains benefit when foreign made parts can be purchased more cheaply as a result of a strong U.S. dollar.
When the U.S. dollar is weak it can lead to price increases on imported goods and services which can lead to inflation. As well the capital value of their assets abroad denominated in foreign currencies is worth somewhat less in U.S. dollars.
U.S. companies with a substantial portion of their sales in foreign markets tend to be correlated. This needs to be thought about on a company by company basis. Put another way, some U.S. companies benefit from a strong dollar and some are hurt. You need to know which is which and ensure you have a balance in your portfolio.
On the other hand, there are U.S. companies whose sales are exclusively within the U.S. and are not affected by either a strong dollar or a weak dollar. To limit one’s portfolio to these companies would unduly restrict your choices.
Emerging markets exposure
Investors must keep in mind that the location of a company’s head office or the location of stock exchange it is listed on do not determine the country or countries where its sales or operations are located. So, for example, an investor interested in exposure to developing markets may be well served by many companies in the S&P 500 index. In 2013, according to the Economist Magazine, some 20 per cent of S&P 500 listed companies sources of revenue were in emerging markets. In fact, only 60 per cent of their sales were in the U.S. Investing in European companies listed locally and contained within the DAX (Germany), FTSE 100 (Britain) and CAC 40 (France) indexes had approximately 20 per cent of their revenues generated in their home countries.
Currencies and companies generally
One cannot avoid currency risks associated with any company. It doesn’t matter if the company is based in your home country or a foreign country. Companies may themselves have their own ways of dealing with currency risk, including having active hedging programs. Companies that export have currency risks, as do companies that import. Companies that operate only within a currency zone also have currency risks if they buy equipment in other countries. This is true of all companies, including U.S. companies.
The U.S. dollar tends to strengthen in time of global turmoil and thus may be considered a hedge against times of crisis. Conversely, the U.S. dollar may weaken in times of global stability.
For a non-U.S. investor, buying US, European or even developing world stocks, provides something of a hedge against their home currency falling against the US dollar. Some feel that the investor in foreign stocks should put in place some currency hedge to counteract the risks of currency fluctuations in foreign stocks. This is really not necessary. It costs to buy hedges and is an expense one does not need to incur. All currencies are subject to significant fluctuations and, one’s home currency, or the currency of the place you plan to retire, are no exceptions. It is easy enough to build natural hedges into the portfolio.
John Templeton was one of America’s greatest ever investors. He was a great proponent of international investing. He wrote in his maxim 15: “If you search worldwide, you will find more bargains and better bargains than by studying only one nation. Also, you gain the safety of diversification.” (Proctor & Phillips, The Templeton Touch. 1983, 2012) p.153.
The first step in dealing with home bias is to recognize it. Then it’s a matter of testing foreign waters and learning from experience. You will improve your skills as an investor and end up with a better portfolio.
To did more deeply into problems investors have grappling with intuitive impressions, take a look at the Motherlode, Chapter 15. Jumping to Conclusions
This Chapter continues with these Sections:
Other posts on investment psychology
This post is part of a series. Readers are invited to read Investment psychology explainer for Mr. Market – introduction This will give you a better understanding of some of the terms and ideas and give you links to other posts in the series.
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