Why Keeping Your Investments Local Is a Bad Strategy

Last Updated Feb 23, 2011 12:03 PM EST

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 bottom line is that there's no evidence that individuals possess "value-relevant" information, and they're overconfident of the information they do possess. In other words, whatever information they have is also known by the market and is already incorporated into prices. The authors even noted that "Individuals do not help incorporate information into stock prices." The other mistake investors could be making is confusing something familiar with something safe.

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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    Larry Swedroe is a principal and director of research for the BAM Alliance. He has authored or co-authored 12 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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