HOME BIAS

People all over the country fill out basketball brackets every March for the NCAA tournament, often putting money behind their guesses. It likely wouldn’t surprise you that the predicted winners vary by geography; that is, people on the East Coast tend to favor East Coast teams whereas people on the West Coast tend to favor West Coast teams. It’s easy to see how that’s the case. People “bet” on what they are most familiar with… even if that familiarity has no bearing on who the eventual winner is likely to be.

Ruining your bracket is one thing. Ruining your retirement is, pardon the pun, a whole other ballgame! Check your 401(k). You may be exhibiting home team bias in more ways than one. First, how much of your 401(k) is invested in your own company’s stock? If the answer in percentage terms is more than single digits then you’re clearly exhibiting home team bias here. Why is this a bad thing? Several reasons. First off, doesn’t your livelihood in the present already depend on this company? Why double down and have your future livelihood dependent on it too? Second, you’re simply opening yourself up to concentration risk. This is another way of saying you’re putting too many of your eggs in one basket. It’s not a judgment on that basket. Great companies can and do fail. They don’t all stay great forever, and you certainly shouldn’t bet your future that your particular company is somehow immune to bad times. No company is.

Aside from putting too much money in company stock, there’s another common home bias that many of us exhibit. It’s called home country bias. We’re unnecessarily fearful of international investment exposure, despite the fact that nearly half the world’s publicly-traded companies exist outside the United States. Again, we gravitate towards the familiar. This means we tend to concentrate our investments domestically. Some years, however, it’s the international investments that outperform. There’s no way of knowing what years those will be. For this reason, when it comes to your long-term investing, it may well make sense to check your home country bias at the door.

HOT HAND BIAS

Remember the classic basketball video game NBA Jam? In it, when a particular player had made several shots in a row the announcer would exclaim “He’s on Fire!” This was a case of fiction mirroring reality… or at least real perception. We tend to think that if a player has made several shots in a row he or she is more likely to make the next one. In basketball, as well as in investing, this statistically simply isn’t the case.1 We feel like it should be true, so we think it’s true. That doesn’t make it so. The bias we’re exhibiting derives its name from its frequent occurrence around the card tables of casinos: the hot hand fallacy.

In investing, the hot hand fallacy comes into play when we’ve had a streak of big wins. We’re on a roll! Our hand is hot! We’ve got this game down! In reality, we may have simply gotten lucky. We fool ourselves into believing that we’re better than we actually are. Likewise, when choosing a mutual fund or other money manager, it’s popular to pick the ones who did the best in the most recent year. Just as is the case with basketball players, the reality is that this method isn’t any more likely to improve results. In fact, due to the odds of outperformance in any given two-year period, these short-sighted selection criteria often produce the opposite of the intended results.2

In investing, as in life, we all have biases. Some are obvious, but some can exist without us knowing it. When putting together a financial plan to help you achieve your life goals, it’s important to recognize your biases and keep them in check. An occasional second opinion from a qualified professional can help make sure your biases aren’t putting your financial future at risk.

1 Gilovich, Vallone, and Tversky, (1985) “The Hot Hand in Basketball: On the Misperception of Random Sequences” Cognitive Psychology Vol. 17, 295-315.

2 Sommer, Jeff “How Many Mutual Funds Routinely Rout the Market? Zero” The New York Times Mar. 14, 2015.

Disclaimer: This article is generalized in nature and should not be considered personalized financial, legal, or tax advice. All information and ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation.

VG PROMOS 937X116
LL IT List Banner 937×117