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Chuck Jaffe

Home cooking isn't good for your portfolio

6/22/12 12:29 PM ET (MarketWatch)Print

BOSTON (MarketWatch)--More than a generation of investors has lived believing the "buy what you know" advice of legendary money manager Peter Lynch, but a new study of professional investors suggests that many are a little too focused on that advice, and that it ramps up the risks they take.

If the pros are suffering for ways they subconsciously get comfortable with the market, one can only imagine how bad the problem is for average folks trying to maintain their sanity in the current market madness.

Allow yourself to imagine it and it may change how you invest.

In a research paper called "No Place Like Home: Familiarity in Mutual Fund Manager Portfolio Choice," authors Veronika Pool, Noah Stoffman and Scott Yonker showed that fund managers overweight stocks from their home state by 12% compared with their peers--and by about three times that percentage if the fund is run by a team of managers--and that buying what they are familiar with leads to risky portfolios.

Home-state stocks do not outperform other investments, so return's aren't getting fat on this home cooking.

The mutual fund industry used to have a number of single-state or regional funds, but investors ultimately realized the folly in holding those kind of limited issues in a global marketplace, where the location of headquarters is a lot less important than the markets a business sells to around the world, so most of those issues either broadened their horizons or shut their doors.

In late 2009, Geary Advisors opened two single-state exchange-traded funds, one for companies based in Texas and the other for Oklahoma, but closed the funds before the fall of 2010, which some observers said would put the single-state concept to bed for good.

Most newspapers still run a "stocks of local interest" list, allowing for quick-and-easy access to the pricing information of companies with a regional presence. Ultimately, that can make an audience feel like those stocks somehow represent the home team.

The point of the researchers, however, is that the pros allow "familiarity bias" to creep into their thinking.

There have been a number of studies which show that familiarity breeds poor performance among individual investors, but the new study shows that it affects pros too. What was interesting is that the results show that a fund manager who is less experienced, and who has fewer resources--typically operating at a smaller firm with a lesser research budget--is more likely to fall back on "what they know."

Even if you consider yourself a savvy investor, your research capabilities and investment experience are likely less than even an inexperienced fund manager; if they get caught in this trap, the chances an average investor will wind up in the same place are greater.

"It does not look like [money managers] are earning higher return s on the [home-state] companies, so it's not like they are informed," said Stoffman. "It looks like they are sort of familiar with the stocks and are choosing them because they think they know something about them, but they don't."

Familiarity not only breeds overconfidence--and the tendency to weight a portfolio with hometown heroes that leaves a portfolio less diversified--but it can convince investors to overlook real safety concerns.

Consider the employees at Enron or Lehman Brothers who had their life savings tied up in company stock at the same time they had their career in the hands of corporate management. They lost a fortune at the same time they were losing their jobs.

Stoffman noted the same could be applied to investors who might be tempted by home cooking.

"What economic research would suggest is that if you live in Oklahoma, you shouldn't buy an Oklahoma fund," Stoffman said. "That fund will do badly just at the time you and your wife lose your jobs. … You would be better off, in terms of hedging your investments against your work, investing internationally or at least someplace where you're not putting so much of your future at risk based on what is happening in your own neighborhood."

That's tough to do at a time when global markets are frothy and volatile.

Russ Koesterich, global chief investment strategist for BlackRock's iShares ETF business, said this week that investors need to achieve a balance between buying what's comfortable and investing where things might make them nervous, but where the diversification helps their portfolio in uncertain times.

"You hear all the folksy wisdom about 'Buy the companies you know' and there's some truth to that," Koesterich said in an appearance on my radio show. "But the reality is that you may wind up with a concentrated portfolio and--in a world where different economies will perform differently at different points in time--having access to emerging markets, having access to Latin America, to Asia both on the stock and the bond side … gives you the opportunity to diversify your risks and not have all your eggs in one basket."

That's not a suggestion to leave the comfort of what you know for investments you don't understand.

Rather, it's a reminder that if you surround yourself in safe, comfortable investments where your motivation is that you "know them," you may be overlooking the additional risks you are taking on.

"I think," said Stoffman, "that consciously or subconsciously people make these decisions because it feels safe and makes them comfortable, and the problem is that in reality it makes their investments less safe and more vulnerable. … No investor, pro or individual, wants to be fooled by thinking they know more than they do, and the fact that you lived someplace and somehow identify with companies from that area just isn't going to give you an edge in these markets."