Why Keeping Your Investments Local Is a Bad Strategy
Many investors let the stocks of local companies make up a disproportionate share of their portfolios. In the U.S., the typical household has about 30 percent of its portfolio invested in stocks headquartered within 250 miles, when just 12 percent of all firms are headquartered within the same radius.
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
The End of the New Normal Quest for Alpha: 10 Rules for Being a Successful Investor Quest for Alpha: What You Need to Consider When Handling Your Own Investing Is Inflation Risk Overstated? How Bond Managers Hide Their Funds' True Risk
Three ways I can help you become a wiser investor:
- Follow me on Twitter: http://twitter.com/larryswedroe.
- Read my latest book The Quest for Alpha.
- Listen to my radio show every Sunday at noon on 550 AM KTRS in St. Louis or streaming via the KTRS Web site. You can also download the podcast of the show via Buckingham Asset Management's iTunes page.