Excessive caution can result in investors avoiding potentially profitable foreign assets. This "home bias" can cost investors a considerable amount of performance. Do you think it's safer to keep your investments close to home? Read on to find out why you might believe this and what you can do about it.
Home bias is an important part of risk aversion and Americans are among the worst culprits. Research conducted in the late '90s by the National Bureau of Economic Research showed that Americans have 90% of their money in local investments, whereas for the U.K. and Germany, for example, the home bias drops to 77.5% and 81.8%. Only Japan reported more home bias, at 94.7%.
Home bias and risk aversion are very common reasons for suboptimal portfolio construction, and the essence of the problem is that people think it is rational to avoid foreign investments, because they seem risky. In reality, they are the opposite in the right proportions, providing diversification, which is so vital to building a good portfolio. In other words, for the portfolio as a whole, an Asian fund, instead of some more American equities, could actually reduce overall risk. (For related reading, see The Importance Of Diversification and Going International.)
Using Neuroeconomics to Understand Risk Aversion
There is more to risk aversion than one might think. It is not just a common mistake reflecting some fleeting opinion at the time, but part of a chemical process in the brains of investors. It can even be detected and depicted on a monitor! Neuroeconomics, an innovative scientific study of the brain, demonstrates that risk aversion and "home bias" have some very real physiological origins and effects.
Magnetic resonance tomography has demonstrated that certain emotional memories can, through actual brain activity, have a negative impact on investment decisions. Fear, in particular, causes chemical processes in the brain.
The tomography process provides remarkable (multi-colored) images of the brain, revealing a lot about the nature of activity there. Fear of losses and risk aversion can be detected visually and the psychological origins determined by research or experiment. In other words, risk aversion may not be something that we can eliminate and, therefore, investors have to learn to overcome this natural tendency in order to increase their chances of investing success.
In Germany, the above concepts were tested in an empirical investigation, which replicated an investment-decision situation. The participating subjects were given a selection of funds to choose from. These were allocated fictional names for the experiment, but linked to actual funds for the purposes of analysis and comparison.
Therefore, the situation directly reflected the real world of investment. The participants weighed the pros and cons of different investments and decided what they believed was right for their risk profiles and personal circumstances. The participants could also win real money, not as much as in real life, but enough to replicate the actual decision-making processes with reasonable accuracy.
Before the experiment started, areas in the brain were identified in which the specific fear of losses associated with home bias would be likely to occur. Higher and different levels of brain activity could be expected if the investors were nervous and wary, as opposed to relaxed and confident. Risk aversion would, therefore, create some specific fear-related "brain waves" and influence the investor.
The participants were then "stimulated" by a variety of choices relating to domestic versus foreign investments. Having to make rather demanding decisions, as in real life, deliberately put the participants in a stressful situation. The basic choice was between two funds in which a participant could choose to "invest".
Through this carefully formulated experiment, it was possible to actually measure how investors' brains reacted to risk-related decisions.
Fear of All Things Foreign
The experiment revealed significantly higher levels of brain activation when the investors were confronted with foreign funds. In other words, investors tended to feel far safer with domestic products on a purely subjective, psychological level and this literally showed up on the monitor and the images. It turned out that this is all about negative emotions and unhappy, painful past memories, and has little to do with rational financial criteria. In other words, the painful past was found to lead to economically irrational behavior in the study's participants and lead to them to make fear-based investment decisions. (To read more, check out Finding Fortune In Foreign ETFs.)
This knowledge has important implications for reducing risk aversion and home bias. The problem is that perceived fear, rather than real risk; it encourages people to avoid perfectly sensible and potentially lucrative investments.
Particularly since the crash of 2000 to 2003, fundamental trust in the industry remains badly shaken, and this can lead people to move from one extreme to the other - from too much risk to too little. Alternatively, they may take the wrong kind of risks by not worrying about an investment at home simply because it is nearby. This geographic proximity is no guarantee of safety.
It should not be difficult to help people overcome at least some degree of this "foreign fear". For example, advisors can establish what kind of investment experiences people have had in the past and help them to understand why things went wrong before. The first step is for people to realize and accept that past investments failed because of avoidable mistakes. This also applies to other negative investment experiences. (To learn more, see Tales From The Trenches: Hindsight Is 20/20 and Removing Barriers To Successful Investing.)
Once this side of the painful past and its real roots have been exposed and explained to clients, they can be shown how and why an appropriately balanced and well-managed portfolio should not lead to a recurrence of past losses and misery. From the neuroeconomic perspective, people can be told that fear really works on or in the brain and can lead to mistakes. (To learn more, read When Fear And Greed Take Over and Master Your Trading Mindtraps.)
Some fear can be productive, and is a natural human emotion, but in the world of investment, it is often dangerous. Excessive, counterproductive risk aversion and home bias need to be confronted and reduced, or eradicated. The basic way to do this is to get good advice about past, present and future investments. Investors should not let emotions and worry push them the wrong way. Rather, they need to find advisors who are worthy of their trust and on whom they can really rely. At the same time, the more people learn and know themselves, the better.
Once people have been stung once, the best cure is insight into why it happened and how it can be avoided in future. This is done by ensuring that investors have balanced, diversified portfolios, and equally importantly, that they really understand them. It is essential to understand how investment risk works (and can be limited), and what constitutes the right level for them. Good research, solid information on the key issues and a sensible international spread of investments, are all indispensable. (To learn more, read Determining Risk And The Risk Pyramid and Using Logic To Examine Risk.)
It is very much a question of finding out what people know or think they know, and establishing the sources of their fears. Investors can then be educated and informed appropriately. The result should be relaxed investors with optimal portfolios!