April 01, 2016
It Can Pay to Get Out of Your Comfort Zone
It Can Pay to Get Out of Your Comfort Zone
Managing emotions is an important part of investing. An experienced Investment Advisor can help with that. We work with clients to prepare a financial plan and help them stick with it over the long term, regardless of market fluctuations.
In recent years, a whole new field of study has evolved called "Behavioural Investing". It explains why people react the way they do and points out mistakes that can arise from normal human attitudes and impact investment returns. But there is a common behavioural trait we see in many portfolios that may not get enough attention – I call it "familiarity bias".
We are more comfortable with the things we know and have had experience with over time. So investors buy household names or perhaps invest in shares of the company they work for. There is nothing inherently wrong with this. Famous investors like Peter Lynch and Warren Buffett have advised us to buy what we know and avoid what we do not understand.
That's good advice, but there can be too much of a good thing if your portfolio becomes overly concentrated as a result. The best and cheapest way to reduce investment risk is diversification. A prudent portfolio will have several asset classes and the equity portion would not allocate more than, say, 5% to any one issuer. Yet we often see concentrated portfolios with no foreign assets, for example, and stock portfolios with 50% or more just in Canadian banks.
Often corporate executives will have more than half their wealth tied up in the stock of their employer. Entrepreneurs who build a business usually plow everything back into it so that it represents all of their net worth. That's a great way to build wealth but it is the opposite of diversification. A different approach is needed when you sell the business to retire and live off the proceeds.
Further, it is common for wealthy clients nearing retirement to have a large home and two vacation properties. Over time, these can be good investments as property values rise and it is not unusual to see real estate account for more than half of the family assets. But property does not generate income and it's expensive to maintain. That may work when salary is still being earned, but in retirement investments are more important to fund living expenses. So too much concentration in real estate may be risky in retirement, even though it feels comfortable to keep the properties you have owned and enjoyed over many years.
Similarly, it is natural for Canadians to own familiar domestic blue chips like the banks or BCE. Also, having most of your investments in Canadian securities can make sense if you plan to retire here. Going with the familiar is comfortable. In contrast, investing in emerging markets or technology stocks can seem risky and therefore out of your comfort zone. Again, this is where we can help.
Staying with the familiar not only leads to over-concentration in certain assets, stocks, or geographies, it also means you may miss better opportunities for investment returns elsewhere. Canadian equities are less than 3% of the global total, and the bulk of the Canadian market is concentrated in only three industrial sectors: financials, energy, and materials. The latter two are commodity-based and therefore volatile and cyclical.
Meanwhile, Canada provides little exposure to technology, healthcare, internet services, or consumer brands. These are the fastest growing parts of the global economy. And domestic companies in these sectors generally are not world leaders (with notable exceptions like Magna or Alimentation Couche-Tard).
Emerging markets now account for about a third of the global economy, and countries like India and Mexico are growing faster than more developed countries where demographics are unfavourable. Investing in foreign markets also provides currency diversification. While we think of Canada as a more stable country than most, our currency dropped almost 35% relative to the US dollar over the past five years.
So diversification is a good idea. Perhaps it is time to move beyond the familiar to opportunities outside your comfort zone. We can work with you to understand them and address your concerns in order to overcome familiarity bias.
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