Balancing an investment pendulum: familiar versus unfamiliar assets
Richard Clark and Simon Patterson, Private Bankers at Barclays Wealth, Newcastle.
There are currently plenty of profits on the table to be taken, with developed stocks now up roughly 20% from their October lows, but focusing on the ongoing risks could mean missing many of the investment opportunities we think are out there.
It’s difficult to get a good handle on all the issues relevant to your investment decisions, so to protect ourselves from making mistakes, we often stick to those areas with which we’re more familiar. This can have both positive and negative investment consequences, depending on how you go about it.
There are thousands of potential investments out there, so how do you choose where to invest? An intuitive ‘safe’ answer is to invest in things you know and with which you are more comfortable. This may be a business you know well, or an economy you understand. This can provide the emotional comfort necessary to invest in risky asset classes, and to start earning the potential associated long-term return premiums. However, familiarity can also lead to underestimating potential risk and overestimating potential return with assets we know well, resulting in getting back less than you have invested.
It is now a commonly held belief that the best portfolios should be diversified across both asset types and geographies. In this framework our inherent bias for familiarity is costly in a financial sense – either lowering return or increasing risk. However it is also necessary for giving the peace of mind to invest. This means that the bias for familiarity is fine up to a point as it can promote positive actions, but too much familiarity bias is likely to be costly and risky.
There is a balance to strike. While it’s not ideal to invest in assets you don’t understand, this doesn’t mean that in a diversified portfolio you need an intimate understanding of all assets.
In addition to expecting higher returns it’s likely that our perceptions of risk are also skewed by familiarity. This can work in two ways. Firstly, our familiarity with the local economy can make us perceive it as being less risky than it actually may be. Added to the perception of higher investment returns this makes the case for investing locally even more compelling. Secondly, investors often add a risk penalty to foreign assets because they simply understand them less. Unfamiliarity with these creates more doubt and the perception of greater risk. This makes investing in foreign markets less appealing.
With these expectations it is rational for investors to increase allocations to their home country. There are steps you can take to use familiarity to your advantage. The biggest hurdle is your own expectations of risk and return for familiar markets. Be aware of these expectations and question whether familiarity is clouding your judgement and causing you to concentrate your investments in one location or market. Often the investment themes for regions are compelling and a lack of familiarity should not be a barrier.
If you find yourself limiting your investments to one market, look to remedy this to avoid being caught out by an overconcentration of risk. In any case, once you start investing in new areas they will automatically become more familiar to you over time.
As always, we do emphasise that investing in shares is not for everyone. Their value can fall and you can get back less than you invest – if you are unsure, you should seek independent advice.
This was posted in Bdaily's Members' News section by Simon Patterson .