Better the Devil You Know and Diversification

If the motto in buying a property is ‘location, location, location’, then the motto for investing should be to ‘diversify, diversify, diversify’. I have often wondered if diversification is so important, why are we only sticking to the things we are familiar with, be it industries or countries?

From the Business Insider Australia,

West Coast investors are 10% more likely than average to invest in the technology industry. The region is home to tech giants Facebook, Google and Apple.

Investors living near the banking centres on the east coast are 23% more likely to own financial stocks than those in the Midwest and 9% more than the average investor.

The South, home to large amounts of the country’s oil reserves, favours energy stocks such as Exxon and Chevron at over 20% more than in the Northeast and 14% more than average.

General Electric, Caterpillar and other industrial heavy-lifters are found in Midwesterners’ portfolios 11% more than average and 20% more than those living on the West Coast.

The one thing all investors can agree on is healthcare stocks with only a -/+3% variance across all four regions.

Perhaps the main obstacle stopping investors from involving themselves in unfamiliar markets is the fact that they lack the knowledge in those markets enough for them to feel comfortable taking the risks. This is known as the Ellsberg paradox, which describes a decision process where it is rational to prefer a lottery with known probabilities to a similar ambiguous lottery where the decision maker does not know the exact probabilities. The English saying for this is, “better the devil you know”.

From a Caltech study,

Equity market home bias presents an interesting problem because the investors are being irrational, in the sense that they are not investing in a pareto-optimal manner: there exists another portfolio allocation such that the investor does not face any higher risk (variance) but receives higher expected return. If people are indeed being irrational with their portfolio selection, then this presents an arbitrage opportunity. In addition, the irrational behaviour raises the question of why investors are not allocating risks efficiently.

Our paper shows that 1) using real world assets there is home bias, and 2) the bias is caused by ambiguity aversion by showing that the investor’s subjective probability over foreign assets is sub-additive.

In conclusion,

We classified about 50% of the participants as ambiguity averse by using the Ellsberg’s urn experiment. Portfolio building with individual companies showed a modest size in home bias. Bond or options with individual companies experiment showed that investors do show higher rate of ambiguity aversion (sub-additivity in probability) when it comes to unfamiliar assets.

The position holding experiment demonstrated that investors do violate the sure-thing principle approximately 20% of the time, and ambiguity averse investors are even more likely to violate the principle. Portfolio building with indices provided evidence that there is home bias in our laboratory setting; investors prefer to buy familiar indices.

Lastly, bond or options with indices experiment also showed that, even with indices, investors exhibit higher rate of ambiguity aversion when investing with unfamiliar indices.

It is natural that we wish for more certainty to help us make decisions. However, as investors, we know that uncertainty is part of the game. We have to think rationally about risk and returns.

While we should by all means embrace our core competencies and allocate significant capital there, to reach for higher returns we must push ourselves to get familiar with the unfamiliar. Failing to do that can carry large opportunity costs.

At the same time, the desire to reduce risk should lead us to seek assets that are as different as possible compared to our core portfolio. It is not hard these days to overlay a few charts to try and identify low correlations even if we don’t want to get down to serious statistical analysis. Diversification is as close as we can get to a free lunch in finance.

There are a few impediments to bear in mind though. Many brokers restrict overseas trading or charge an arm and a leg for it. The exchange rate, language barrier, information asymmetry and information immobility add to the reasons why it would be more challenging to invest internationally. Thankfully, with the ever increasing number of ETFs, we have now short-cuts available to more optimal portfolios if we don’t want to bear the costs of researching and trading individual companies in foreign markets.

No matter how well things are going in the markets we are comfortable with, shutting our eyes to opportunities elsewhere can deprive us of even better returns while the added diversification will usually provide a smoother ride.