“Invest in what you know.” – Peter Lynch
Successful wealth management requires us to construct diverse investment portfolios made up of different asset classes, including stocks. In choosing our investments we often have biases that unknowingly create challenges as market cycles change.
Peter Lynch, famed manager of the Fidelity Magellan Fund, popularized the idea that investors could succeed by picking stocks that they knew best. Put into practice in 2021, that might sound like this: I use Amazon Prime. I understand the value of the service and how it will grow over time. Therefore, I will buy Amazon stock.
Decades after Lynch made his mark on investing, we learned there is a downside to investing in what you know. In fact, it’s possible that we invest too much in what is familiar, and that bias inhibits our ability to seek returns and manage risk.
For many investors, what they know best are the stocks of their own country. They often ignore the opportunities that exist abroad. The chart below depicts this phenomenon of “home bias” and how much investors favor stocks in their own country over a more global portfolio.
Americans, for example, invest 75% of their equity holdings in U.S. stocks, even though domestic stocks represent only 55% of the global stock market. That feels out of proportion but not nearly as extreme as in smaller economies. For example, Australians invest over 60% of their holdings at home even though their market represents only 2% of the global stock market.
Staying close to home indicates comfort with what we know, but this bias could introduce unnecessary risk and limit opportunities for growth in a family’s wealth management plan.
Historic Global Market Performance
The beginning of 2021 is a good time to reflect on home bias due to the performance of the global stock market over the last decade. If you concentrated your investments in U.S stocks since the Great Financial Crisis, maybe in an S&P 500 index, you are probably feeling good about your returns. Any money invested internationally lagged behind consistently. For those of us in the U.S., home bias has been rewarded for a long time. However, that has not always been the case.
Market leadership changes over time…long periods of time. We can look back, almost decade-by-decade, to see where the geography of performance has ebbed and flowed. In the 1980’s, international stocks outperformed U.S. stocks by almost 6% annually. Then, in the 1990’s, the dot-com boom powered U.S. stocks well above their international peers. Following the burst of the tech bubble, the 2000’s were a “Lost Decade” for the S&P 500, lagging behind a booming Europe and China. Finally, there is the last decade where the U.S. markets have outperformed international markets by 6% annually.
Current Global Market Movement
Why do these changes in leadership happen? It comes down to value. Investors who ride rising markets higher eventually start to take profits and look for less expensive places to invest. We may be seeing just such a time right now. The recovery in the stock market since the lows of 2020 has had two unique phases defined by which companies were leading the way.
The first phase of the market recovery through the Spring and Summer of 2020 was led by many of the same technology focused companies that were leading prior to COVID-19. International stocks trailed behind until the Fall when the technology rally stalled and the second phase began with a more global rally. The S&P 500 still finished 2020 with strong returns, but the rally in international stocks over the last two months of 2020 raised many eyebrows.
In the three months ending January 31, 2021, the S&P 500 was up over 14%, but that was dwarfed by the EAFE international index (+19%) and the MSCI emerging markets index (+20%). For a long time, concentration in a few stocks (tech) in one country (the U.S) worked very well for investors. Recently, though, it is diversification that is being rewarded.
Home Bias and Your Wealth Management Strategy
At times like this, diversification can enhance returns, but it can also help to manage risk. Some countries tend to have high concentrations in particular industries. Home bias in Canada might mean overexposure to energy. In Germany, it is the automotive sector. In the U.S., it’s technology. Just as each stock represents a unique risk, so does each country.
Many investors are concerned about the U.S. stock market reaching all-time highs and that it has become overvalued. An investor who is concentrated in S&P 500 might find this a good time to diversify internationally where valuations are not as steep as they are domestically. As Harry Markowitz famously said, “diversification is the only free lunch” in investing. Recognizing home bias would be a worthy first step for investors to control what they can control in 2021.
Dennis Morton and Cody Demmel, of Morton Brown Family Wealth, provide investment and financial planning guidance to families looking to be more intentional with their wealth. They can be reached at firstname.lastname@example.org, or Cody at email@example.com.