05 January 2017
Local (and not so local) investment heroes
To tip or not to tip?
by Frank O’Nomics
It’s the time of the year when people ask for your views on the best stock selections for the next 12 months.
If you play a musical instrument and a friend asks you to play them something, is it rude not to decline? Similarly, if you are an investment professional and someone asks you for a share tip, should you readily oblige? The answer to both questions depends a lot on the questioner’s motives. Are they just making polite conversation or are they really looking for something free? The musical analogy is probably best left at this stage, but the answer to the investment question is worth examining, as transferring knowledge in this way is quite dangerous and is one of the reasons why people finish up with some strangely distorted portfolios. Much as most people try to be rational regarding their investments it seems that there are 3 over-riding factors which distort their choices.
The first is a very strong bias based on locality. We invest much more in companies in our home nation, and often in our own town, because these are stocks that we feel we know the most about. I’m sure you are well aware of the products and services of Marks and Spencer, but probably less au fait with other FTSE 100 companies such as Antofagasta, much of whose business is based in South America. The second bias is familiarity. If you work in the financial services sector there is a strong chance that you will have invested in that sector because you are constantly involved in it. These biases can themselves leave us with very distorted investment portfolios, which ignore potential offered elsewhere. However, it is the third bias that is perhaps the most dangerous – and this is where listening to share tips is ill advised – and that is the key influencer bias. It seems that we have a disproportionate regard for the advice of those wealthy, supposedly well informed, or active investors who have a loud voice.
You might ask: “Why should any of this be a problem?” We can argue that we have a knowledge advantage derived from our locality, or familiarity with a product, and should utilize the experience and wisdom of others. However, the chances of an investment being good just because it is local seems somewhat remote, and those who talk loudly about their investments are often either looking for confirmation that they are doing the right thing, and/or for your support in the investment, which will mak their optimism self-fulfilling. If you buy the last flat left in the block, the secondary price of the rest is likely to rise.
Let’s look further at these biases. On a national level, the tendency for US investors to buy US stocks and UK investors to buy UK stocks, is historically huge: around 90% and 80% respectively. Even nations with more modest domestic opportunities do not look very far, with Canadians investing predominantly in the US and the French in the UK. On a more local level, there is also a very high chance that people will invest in companies near where they live. There are some obvious positives for local investing, in that you are well placed to understand your national economic outlook and, for local companies, you may have direct contact with those working for the companies and can gain a good impression of their current performance – is your best friend missing pub visits due to over-time resulting from new contracts? For example, those in Leicester who spotted the potential for local company Next, saw an investment made at £8 per share in 2008 rise to £80 by 2015, and buyers of the other local star, Dunelm, saw its price rise from under £2 to £10 over just a 4 year period. However isolated outperformance is one thing: more recently both of these stocks have had an indifferent record, and those investors who look at a balanced global portfolio of stocks will be faring much better. In the same way, buy-to-let purchases of central London flats will have looked very clever for a number of years due to the impressive capital appreciation, but it may well be that investors would now be better targeting a 6% yield in the Midlands, rather than a 3.5% return in the capital. Local bias, however, means that few will contemplate the alternatives beyond the Watford Gap.
The investment bias that comes from living near a key influencer is perhaps more significant, particularly when looked at over time. Raghavendra Rau and Robert Wardrop of Cambridge University have been able to survey the bond investors of a small German engineering company over a 15-year period and the results are illuminating. At the outset, with early bond issues, much of the investment came from people living close to the company. That is not surprising, given that they would have been familiar with what it did and would have some degree of comfort regarding the loan being repaid. However, over time clusters of investors built up in other areas of Germany, and these were centred around a number of large, regular investors. What was clear here, was that a small number of wealthy, active and vocal investors was having a significant influence on the behavior of other investors over time, and that this influence became a much more significant driver than the local bias that drove early investment. Only one overseas pool of investors stood out, and that was based in Majorca. Surprising? Not really – given that a great many wealthy Germans have retired to the island over the last few decades.
What this research suggests is that your proximity to an evangelical investor is, over time, more important than your proximity to a company. For those who are trying to raise money this could be critical information in making the process most efficient. If you can just get a small number of evangelical investors involved, they may well do the rest for you. For the rest of us, while we may have long been investing largely in the devil we know, it is more likely that we are being influenced by vocal large investors – and in this knowledge we should be actively questioning their motives in informing us of their choices. So, take a look at your investment portfolio and try to work out just what were the influences that drove your selection – and stop asking people for share tips, as they will find it hard to refuse.
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