Globally recognised expert in applied decision science, behavioural finance, and financial wellbeing, as well as a specialist in both the theory and practice of risk profiling. He started the banking world’s first behavioural finance team as Head of Behavioural-Quant Finance at Barclays, which he built and led for a decade from 2006.
A core investing lesson is that diversification is a good thing, perhaps even a financial free lunch. As a guide to someone having a basic grasp of sensible investment essentials, it's right up there with knowing that investing is a long-term pursuit and that past performance is no guarantee of future performance.
While short-term crashes can correlate across countries, over the long run, markets that live apart, die apart. International diversification thus protects long-term investors from the risk of a country going missing for a decade or two – something that can be especially useful if that same country is also paying one's wages.
Yet across the world, portfolios constructed by both amateurs and professionals make a conscious effort to ignore international diversification, often to a considerable degree.
Other studies have suggested that were UK investors' holdings in UK stocks to be based only on economic expectations, they would have to believe that UK stocks were headed for an outperformance of historical proportions.
Broadly speaking, a country's (or a company's) long-term expected return is determined by its cost of capital. Riskier ventures pay more for capital. If they didn't, capital would flow to places offering the same return at a lower risk. Over the long term, cost of capital across developed markets is inevitably going to be similar and stable (and thus non-domestic risk-return and cost trade-offs are likely to be negligible). So why is the observed anti-diversification stance so strong?
The answer – as ever where the technically 'correct' deviates from the practically observed – is that people buy stories, not investments. Without a supporting framework of fairytale-esque familiarity, diversification leads to discomfort. Viewed from another angle, familiarity breeds unjustifiable comfort: investors have an innate, and costly, preference for concentrated portfolios of nice narratives, rather than diversified portfolios of good investments.
Investors pick not the answer that keeps the textbook happy, but the one that keeps themselves happy. That delivers not an impersonal theoretically optimal risk-adjusted return, but a personal, and often costly, anxiety-adjusted return: they give up financial efficiency for emotional comfort. If diversification causes distress, it ceases to be such an obviously smart idea. A certain amount of home bias can be useful in buying emotional comfort at relatively low cost, but most investors veer too much to the familiar, and pay too much as a result.
The key is not to brush away such concerns, but to put in place a plan – by adjusting a combination of investment, decision-making, and communication levers – that ensures the price paid for the sought-for emotional comfort is no higher than it needs to be.
Home bias is not about geography. While a home bias may in many cases feel like it is combatting country or currency risks, because of the globalisation of the world's biggest companies, it is actually about sector risks – concentration in companies of a particular type, not countries in a particular location. And while tax and transaction costs may also have roles to play, they are relatively minor ones.
For example, approximately three-quarters of UK equity market revenues come from overseas. However, certain industries are heavily overweighted relative to the global market, especially so as the UK market is highly concentrated, with the top 10 companies representing nearly half of its total market capitalisation. A portfolio with a UK bias isn't betting on the UK; it's betting on a handful of energy and telecom firms.
This thinking also leads people to favour discrimination over diversification. Thinking home bias is about countries rather than sectors can lead people to make decisions driven by xenophobia, or personal speculations; people don't have as strong prejudices against telecoms as they do against Trump, say.
The question of currency risk is a little more complicated. However, in the long-run, currency fluctuations should even out, and in the short-term currencies exhibit equity-like volatility, which reduces international correlations somewhat, adding to the diversification advantage. Currency movements can help or hinder returns, and outside of fixed-income securities, they do neither systematically.
Investors may derive emotional comfort from backing the home team, but in practice this support is misplaced at best, illusory at worst.
From an abstract fear of the unknown, to peer-group regret avoidance, to simple, but not necessarily pure, xenophobia, investors may derive comfort from the devils they know in several ways.
While changes to investments could be called for – of all the deviations from the 'optimal' portfolio, a limited amount of home bias is one of the better ones – changes to the decision-making processes and communications that surround the investments are a more cost-effective means to the same ends. Even when deliberate home bias is a cost-effective source of emotional comfort, it's even more so when accompanied by narratives that draw investor attention to the more naturally familiar components of a portfolio. Because humans neglect scale in narratives, a story emphasising a holding making up, say, 5% of a portfolio may provide comfort with 100% of it.
Other examples include: encouraging phasing for acclimatising to foreign assets; agreeing to govern decisions by pre-set rules, thus diminishing the emotional pull of in-the-moment prejudices; bundling familiar and unfamiliar assets together; and focusing reports on high-level stories rather than individual component performances.
Knowing which solutions to adopt in which circumstances means knowing the investor they're being adopted by. Deviations are unnecessary if the investor doesn't care in the first place, and different sources of discomfort call for different remedies. The key to this is profiling, which is why Familiarity Preference is one element of Oxford Risk's Financial Personality Assessment.
A high preference for familiar investments can tailor not only the adviser-client relationship, but also an investor's education, for example, specific training to become less attached to home-market benchmarks.
While the optimal ratio of home to overseas assets is unclear, skewing a portfolio on the grounds of geographic familiarity is unsupported… economically, at least.
Investors are humans, and as such are, in the words of J.G. Ballard, 'Desperate for the new, but disappointed with anything but the familiar'. When moving into the new world of investments, it's important not to confuse familiarity with safety (it can be the reverse!) nor to blindly adopt unnecessarily expensive solutions to problems that lie more with perceptions than portfolios.
A version of this originally appeared on Momentum.co.za.