Last Updated Feb 23, 2011 12:03 PM EST
The only logical reason for investors to overweight local firms is that they must believe their local presence provides them with an information advantage that enables them to generate abnormal profits (alpha). The problem is that you're familiarity with a company doesn't mean you going to be right about its stock performance. And the data shows that most get it wrong.
In the study "Individual Investors and Local Bias," Mark Seasholes and Ning Zhu found that the returns of local stocks investors purchased badly lagged the returns of local stocks sold. In other words, "knowing" a company didn't help investors get the timing right. They also found:
- Such underperformance was still true for smaller, less-analyzed companies, or companies where familiarity may be an advantage.
- Portfolios of local holdings didn't outperform on a risk-adjusted basis, even before considering transactions costs.
- The average return of the Buys-minus-Sells portfolio was -1.7 percent per year. When confining the analysis to only trades of local non-S&P 500 Index stocks, the Buys-minus-Sells portfolio has a return of -2.3 percent per year.
The findings of this study provide us with a simple solution to investment strategy decisions. Instead of relying on your "knowledge" of local companies:
- Minimize transaction costs
- Maximize tax efficiency
- Capture market returns through indexing or passive investing
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