How To Remove Familiarity Bias From Your Portfolio

 |  Includes: AAPL, CAT, JNJ, KO, PG
by: Efficient Alpha

By Mario Mainelli

This continues our series of articles written exploring the myths in popular investing as exposed in Michael Dever’s new book, “Jackass Investing.” In the book, Dever uses experience from three decades of hedge fund management to explore how the conventional wisdom in investing and portfolio management preaches little more than gambling. For an introduction to the series and the book, see our previous article looking at the return drivers for stocks.

In this article, I will be covering Myth 16, Allocate a Small Amount to Foreign Stocks, which I’ve further broken down into two subsections, The Home Team Bias and Company Location and Market Correlation.
The Home Team Bias
The home team bias is a relatively well-known concept in which people tend to bet sports teams with their hearts rather than their brains. The author demonstrates this concept with an example using a football game between the New York Giants and their long-time rivals, the Philadelphia Eagles. The two teams had an identical record going into the game, so the odds of victory should have been very close to 50/50. However, a poll conducted before the game showed that 74% of Giants fans picked the Giants to win, and a whopping 93% of Eagles fans picked the Eagles to win. Ah, home team bias at its finest!
While the home team bias among sports fans is well-known, its application to investing is less recognized. Familiarity bias states that investors tend to favor investment choices that are more familiar to them. The familiarity with the company, whether through advertising or national identity leads the investor to assume that the company is a better investment. This causes investors to over-allocate funds to investments in companies that are headquartered within their own country.
One would assume that investors don’t pick stocks because they like the company, but rather because they believe the stock will increase in value. However according to the author, “Virtually all ‘investors’ behave as irrationally as if they were betting on a football game – they overwhelmingly favor the home team and allocate disproportionately to stocks of companies domiciled in their home country.” The biggest offenders of the home bias rule, according to the author, are Japanese investors, who invest 83.7% of their portfolio in Japanese stocks, even though the Japanese markets account for only 9% of the world’s capitalization. If investors were rational, one would assume that domestic and foreign investors would hold approximately the same allocations across country exposures, barring any regulations that would limit foreign investment. Investors shouldn’t simply overweight in domestic stock, but rather they should allocate a specific amount that fits their market outlook and diversification needs.
I both disagree and agree with this argument. First the disagreement - it is reasonable for investors to have a higher portfolio weighting in domestic stock simply because this is the market that the investor knows the best. International investing introduces a whole new world of additional risks, chiefly currency risk and economic risk. The currency risk can partially be eliminated through the use of American Depository Receipts (ADRs), which are shares of foreign stock listed on American stock exchanges. But, even then, the currency risk is not fully eliminated because dividend payments are converted from the stock’s home currency to US dollars. Investors typically understand how the economy in their own country works to a much better extent than the economies in other parts of the world.
While I believe investors should overweight their portfolios with domestic stocks, I do agree that perhaps it is done to a further extent than necessary. The author points out that US investors invest 50% of their money to US companies, despite US stocks accounting for approximately 30% of world capitalization. This is certainly too high given the long-term outlook for growth in the US or any of the developed markets. While investors will most likely own a larger percentage of domestic stocks relative to the stocks domiciled in any other individual country, the share of domestic stocks should not constitute a majority of the total portfolio.
A Company’s Location and Market Correlation
The author’s next subject is a company’s location and how it affects the returns of the stock. It’s shown that the location of a company’s headquarters is not particularly relevant as a return driver. This is best understood through an example of Coca Cola (KO). You’ve done your research and decide that Coca Cola is the right company in which to invest, partly for its exposure to the U.S. outlook. Is Coca Cola truly an American company though, considering close to 80% of its profits are generated abroad? Though KO is an American-domiciled company, the stock does not necessarily provide exposure to the U.S. market to the extent that investors believe.
The author is pointing out that, while Coke may be more linked to the US economy than other economies, Coke’s value is still dependent on many economies. Thus, one shouldn’t simply peg it as a US stock without considering what else may truly drive its value. I’ve included a table of other “US” companies that have greater international sales than domestic. These stocks; Johnson & Johnson (JNJ), Caterpillar (CAT), Apple (OTC:APPL), and Proctor & Gamble (PG) all have a significant amount of their value driven by international markets.
This introduces us to the correlations between the world’s major stock markets. The conventional wisdom has always held that investing a portion of funds within each of these markets provides for a sufficient level of diversification given differing stages within the business cycle. The chart below shows the performance of the Exchange Traded Funds for ten major countries’ stock indices throughout the 2008 Global Financial Crisis. One of the key developments of the recent crisis has been higher correlations across markets and a breakdown of diversification.
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Though much of this effect was caused by the enormity of the crisis the author also displays similar results for the bull market of 2002 to 2007. As a result of globalization and the crisis, equities have provided the least amount of diversification exactly when investors needed it most.
The author’s main point here, and what I believe is a major theme throughout the book, is that you cannot simply diversify your portfolio by spreading your money to various equities or equity markets, because equities tend to have the same return drivers. Instead, diversification across different return drivers and strategies provides for a less volatile and better performing portfolio.
Again, I am somewhat torn here. I agree with the macroeconomic theory at play. In periods of severe crisis or unsustainable expansion, broad market indices of different countries will move together, as shown above. This is simply because investors, regardless of location, will begin to feel strongly bullish or bearish and pursue similar investment strategies. Furthermore, I agree with the author’s viewpoint that investors should incorporate multiple diversified trading strategies, each based on a unique return driver, into a “truly” diversified portfolio. A long equity position is neither central nor primary, but is just one of the many trading strategies that can be included. This is a major differentiator in his approach to portfolio diversification, in contrast to the long stocks & bonds approach that is conventionally-preached as a portfolio allocation strategy.
I still believe that investors can achieve a sufficient amount of diversification in equities however. The examples provided show performance across an entire country’s market, but some sectors within these markets will perform differently given different stages in the market cycle. For example, an investor could achieve some diversification by investing in defensive stocks (which tend to relatively outperform in recessions but relatively underperform in expansions) with an allocation in cyclical stocks (which tend to relatively underperform in recessions and outperform in expansions). The author would likely disagree with this however. That is because he is interested in creating a portfolio that can profit even in equity bear markets, not merely ‘outperform.”
Action Strategies
The action strategy for this chapter shows how one can create a diversified international portfolio using 25 ETFs from various countries. The author divides countries into three broad categories. Developed markets, such as the US, Canada, and Germany, are generally the most liquid and well-established of the three. Emerging markets, such as Mexico and Russia, are less active and have lower regulations. Lastly, there are Frontier markets, like Vietnam and Pakistan, which have the lowest liquidity and market capitalization.
Investors using the strategy will compose the portfolio from the list of country-specific ETFs that have a positive rate of change in price over the past 42 trading days. A 5% allocation in the fund is made and held for a minimum of 30 days or until the rate of change turns negative. This means that the portfolio will include a maximum of 20 from the 25 country funds. The rate of change is a momentum indicator that implies a positive future trend. The author also recommends adding some exposure to frontier markets for the purpose of diversification. While developed markets and emerging markets are highly correlated (.92 correlation), frontier markets are considerably less so with a .64 correlation to developed markets and a .59 correlation to emerging markets.
The following graph shows how the international allocation strategy has performed vs. a world index fund over the last 10 years. The strategy has outperformed the index by about 7.5% while reducing annualized volatility significantly.

Below is a portfolio strategy that I have developed, which places an emphasis on the author’s techniques from this chapter. The author only briefly touches on the subject of using multiple trading strategies in this chapter, but he does stress its importance in other chapters. In fact, it is a major theme throughout the book (culminating in the final chapter). While I think the exposure to fixed income, gold, and commodities are a great addition to the portfolio because of their low or negative correlation to the market, the author would simply view these positions as just a fixed, long-only trading strategy applied to each of those markets. I’ve also included exposure to developed, emerging, and frontier markets. The portfolio has a 40% weighting on developed market equity. A weighted average beta of .57 means that the portfolio should be less volatile than the market in general.

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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Disclaimer: : This series has been written on a contracted basis with the book's author. The opinions expressed in the article are those of Efficient Alpha and not necessarily those of the book's author. Efficient Alpha has been contracted to describe strategies and concepts used within the book but not to promote or recommend any strategies, the author, or the author's services.