THE COUNTRY.
Figure 11.2
United States Japan
United Kingdom 93.8% 98.1% 82.0% 47.8% 26.5% 13.8% 0.0% 25.0% 50.0% 75.0% 100.0% Market Weight Domestic Investor Ownership
On average, the companies that a professional money manager buys are headquartered 100 miles closer to the manager’s office than the typical U.S. company.8
Familiarity Breeds Investment Problems
What company are you most familiar with? Generally, you are most familiar with the company you work for. This familiarity causes employees to invest their pension money in the company stock. For example, most company 401(k) pension plans allow employees to invest money in options like a diversified stock fund, a bond fund, and money market instruments. One common option is the com- pany’s stock.
Modern portfolio theory suggests that employees diversify their retirement assets, selecting diversified stock, bond, and money mar- ket funds as needed according to their risk tolerance. Selecting the stock of one company is not diversified. Considering that people already have their labor capital tied up in the company, to fully diver- sify, they should avoid investing their financial capital too.
If your job and your retirement assets depend on one company, you could be in for a shock. Consider the plight of the employees of Color Tile, a Fort Worth, Texas, home decoration retailer. Because the company has declared bankruptcy, many of the 1,362 pension plan participants may lose both their jobs and much of their retire- ment money—the $20 million pension plan was heavily invested in company stock. The stock of companies declaring bankruptcy fre- quently becomes nearly worthless in bankruptcy court. Even large established companies can go bankrupt. For example, on April 6, 2001, Pacific Gas and Electric, California’s largest utility, filed for bankruptcy.
Your company doesn’t have to go bankrupt for you to be adversely affected. Several employees of Miller Brewing Company were going to retire early. Philip Morris owns Miller. Unfortunately, these employees had most of their 401(k) investments in Philip Morris stock. Near the end of 1998, Philip Morris stock peaked at $56 a share. By the end of 1999 the stock had fallen to $23. If these employees has been planning to retire on a nest egg of $500,000, that egg would have shrunk to nearly $200,000. This 59% loss occurred during a time when the general stock market (the S&P 500 index) advanced by 26%. What are the consequences for these employees? Early retirement will probably not be an option. Fortunately, Philip
INVESTMENT MADNESS:How psychology affects your investing…and what to do about it 119
Morris began a partial rebound in 2000. By year end, the stock had risen to $44.
Just how common is it for employees to invest their retirement money in their company’s stock? In a survey of 246 of America’s largest companies, 42% of the total 401(k) plan assets were invested in the company stock.9 Employees themselves make this decision. They like investing in the company stock because it is familiar.
When you are familiar with something, you have a distorted perception of it. Fans of a sports team think their team has a higher chance of winning than those who are not fans of the team. Investors look favorably on investments they are familiar with. They believe that familiar investments will deliver higher returns and that they have less risk than nonfamiliar investments. For example, Americans believe that the next year’s U.S. stock market will per- form better than the German stock market. Meanwhile, Germans believe their stock market will perform better. Employees believe that the stock of their employer is a safer investment than a diversi- fied stock portfolio.
The brain often uses the familiarity shortcut to evaluate invest- ments. This can cause you to invest too much money in the stocks that are most familiar to you, like your employer’s stock. Ultimately, this leads to underdiversification. You allocate too much of your wealth to your employer, local companies, and domestic stocks.
The next part of the book broadens the scope of consideration to the sweeping impact of the arrival of the Internet and how that has magnified your psychological biases.
ENDNOTES
1. Hersh Shefrin, 2000, Beyond Green and Fear: Understanding
Behavioral Finance and the Psychology of Investing, Boston,
Massachusetts: Harvard Business School Press, 81–83; Hersh Shefrin and Meir Statman, 1995, “Making Sense of Beta, Size, and Book-to-Market,” Journal of Portfolio Management: Winter, 26–34; Michael Solt and Meir Statman, 1989, “Good Companies, Bad Stocks,” Journal of Portfolio Management: Summer, 39–44.
2. Josef Lakonishok, Andrei Shleifer, and Robert Vishny, 1994, “Contrarian Investment, Extrapolation, and Risk,” Journal of
Finance 48: 1541–78, table 1, panels C and D.
3. Werner De Bondt and Richard Thaler, 1985, “Does the Stock Market Overreact?” Journal of Finance 40: 793–808.
4. Much of this discussion is adapted from Gur Huberman, 1999, “Familiarity Breeds Investment,” forthcoming, Review
of Financial Studies.
5. The data for the figure came from Kenneth French and James Poterba, 1991, “Investor Diversification and International Equity Markets,” American Economic Review 81: 222–26, table 1.
6. Jun-Koo Kang and Rene Stulz, 1997, “Why Is There a Home Bias? An Analysis of Foreign Portfolio Equity Ownership in Japan,” Journal of Financial Economics 46: 3–28.
7. Nikhil Deogun, 1997, “The Legacy: Roberto Goizueta Led Coca-Cola Stock Surge, and Its Home Prospers,” Wall Street
Journal, October 20.
8. Joshua Coval and Tobias Moskowitz, 1999, “Home Bias at Home: Local Equity Preference in Domestic Portfolios,”
Journal of Finance 54: 2045–73.
9. Ellen Schultz, 1996, “Color Tile Offers Sad Lessons for Investors in 401(k) Plans,” Wall Street Journal, June 5; Ellen Schultz, 1996, “Workers Put Too Much in Their Employer’s Stock,” Wall Street Journal, September 13.
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