You Don’t Need To Understand Your Investments

Posted on March 21, 2013 at 11:45 AM PDT by

You don’t need to understand your investments. At first blush, that sounds like a terrible thing to say, doesn’t it?

It certainly is the opposite of common sense from a business perspective. Surely, if you decide to open a bookstore or a café, you better know a thing or two about customer service, hiring, financing and supplies.

On the other hand, not really. There are plenty of entrepreneurs who simply look for a working business to buy, hire the talent to run it right, and worry instead about keeping the books straight.

understand your investments

Nevertheless, “uniqueness” is a common marketing message from the big consumer brokerages. They spin the story nearly non-stop: You are an individual. One of a kind. You should invest in a “style” that fits you.

You can beat the market, they tell you, by following your heart, your gut, your brains…something will guide you to great performance.

We see this kind of invest-what-you-know thinking most clearly in what economists call “home bias,” our tendency to invest heavily inside our own borders. Among a group of major open world economies, for instance, the focus on domestic company stocks is evident.

The Swiss, for instance, have about half of their money in stocks in Switzerland; the Brazilians and Chinese around 99% at home.

In the United States, it’s 77.2%. You might say, well, U.S. firms get a lot of their money from overseas. And that’s true. But that’s not how U.S. investors look at it.

Much like their foreign peers, Americans look to see if they recognize the brand name and they buy, over and done. It’s not about diversification at all.

The trouble with all this is that investors would benefit greatly from adding foreign stocks to their large home-based holdings. The reason why is growth.

Much like small-cap stocks (which suffer from a lack of brand name, too), emerging market and foreign developed country stocks can give your portfolio the extra gas it needs.

Conversely, investors in smaller foreign economies are probably taking too much risk when they load up on home-based stocks and ignore the rest of the world.

Of course, their markets are structurally different. Tax and retirement plan barriers crop up. Costs can be higher, information less available and exchange rates are tricky.

Once you subtract all that out — and U.S. investors certainly are free to buy nearly any and every asset under the sun these days — home bias persists. Why?

I would suggest it’s largely because we believe that we understand the companies we grew up with and whose places of business we frequent every day. It’s comforting to see a McDonald’s restaurant on the highway or a FedEx truck in traffic and think, “There’s a little bit of my retirement, working for me!”

Nevertheless, it’s simply not true. You have no idea how well or how poorly management is doing at any given firm in which you might invest.

You might have time to read the quarterly reports, but there’s nothing you can do about anything you see there. Vote your infinitesimally tiny proxy? Hardly.

The professionals are caught flat-footed all the time by information they don’t have or events and people beyond their control. Their models are forward-looking but their inputs are all from the past or simply guesses at the future. Even company insiders buy and sell at the wrong times.

Which is a way of pointing out that nobody really understands their investments. We like the illusion that it’s possible, but truly the only way to know is to own enough of a company’s shares to control  the majority of board seats and install your own CEO.

That’s impossible, so we console ourselves with the idea that owning the well-known names brings us closer to what’s going on.

Understand your investments bias

It’s an illusion. Perhaps better said, a bias, one that robs you of performance over time.

Truly, a global, balanced portfolio is the most effective route for retirement investors, but going that way means you have to accept the idea that you own stocks, not companies. Tickers, not businesses.

The billionaire Warren Buffett can go all in on a single name and really change things up to his advantage.

The rest of us? We’re better off accepting the facts and owning a broad mix of asset classes, rebalancing over time to capture gains as they happen.