We’re taking a cue from social media this week. Instead of “Throwback Thursday” -which is when people post pictures of themselves from their distant past on Facebook, Twitter and the like – we’re going to do “Way Back Wednesday”. Today’s “Way Back Wednesday” is going to include a story from 1984 to illustrate a predisposition that still poses risks to investors today.
And just to acknowledge the irony of me telling this story, I will admit that if I posted a photo of myself from 1984 I would most certainly be wearing a diaper.
As many of you know, in the early 80’s AT&T, Aka Ma Bell was required to divest its holdings in its regional telephone service providers dubbed the Baby Bells. This was the result of anti-trust lawsuit filed in the 70’s but it wasn’t until January 1, 1984 that the Baby Bells actually came into existence as the Regional Bell Operating Companies. If you were a shareholder of AT&T before this divestment, you would receive 1 share of each of the 7 Baby Bell companies for every 10 shares of AT&T you owned.
From then on, if you lived in the South you used Bell South for telephone service, if you lived on the West Coast you used Pacific Telesis. As a consumer you became familiar with your local company. As an investor, you owned shares of all the Baby Bells, even those nowhere near your region. What happened next is the interesting part. People started to sell the shares of stock in companies outside their region, but they would keep the stock of their local Baby Bell. This happened en masse. It was as if most of the Bell South stock had suddenly migrated to portfolios of individuals who lived in the South and the Pacific Telesis stock started showing up in portfolios of people living out West.
Why would this happen? Well, quite simply because people invest in what they know. Sometimes this is called “home bias”. If you use Pacific Telesis phone service every day, see their signs and trucks around your neighborhood, and pay their bill each month you become familiar with the company. You might even like the company’s services or products, which influences us when we think about what stocks we want in our portfolios.
This isn’t necessarily a bad thing. If grandma wants to give each of the grandkids a couple shares of Disney or McDonald’s for holidays, so be it. What we need to be cautious about is investing ONLY in things we’re familiar with and letting our familiarity, or even favor, get confused with suitability for our portfolios.
There are two examples where we see this home or familiarity bias come into play most often. The first is with folks who work for publicly traded companies. It’s easy to understand why this would happen. As an employee, people spend their careers dedicating their efforts to bettering a company. They spend their day hearing about or setting its direction, discussing changes around the water cooler. It feels personal and better yet, it feels safe. Yet, in reality, no matter how good the company is, investing all their resources in it is one of the least safe things they can do. They already have a lot hinging on the future success of the business: their salary, their bonus, and other compensation like stock options or restricted stock. Other than contributing as much as possible to the company’s success, there isn’t a whole lot they can do to mitigate that risk. They can, however, choose whether or not to further concentrate that risk by investing their portfolios in the company stock. Putting their portfolios into a more diversified set of holdings provides a tremendous ability to reduce risk, while still giving them the ability to enjoy the company’s future success through payroll or incentive increases.
The other example that often comes up when we talk about home bias is that investors (and a lot of advisors) are likely to put a higher-than-average amount of domestic stock in their portfolios. If you’re American, you tend to have a lot of US stocks. Citizens of other countries are the same way, but in order to be truly diversified, you need to own stocks in places other than your home country. The US only makes up about half of the world’s equity markets, which is why we allocate a significant amount of our portfolios to the rest of the world. This year in particular we’re seeing the benefits of that diversification as international markets are outperforming the S&P by 5% or more year-to-date.
All this to say, the devil you know may not be better than the one you don’t when it comes to investing in your portfolio. The benefits of diversification may be an old story, but what else can you expect on “Way Back Wednesday?”
Have a good week!