By Julia Rees, CFA
Julia Rees is a senior portfolio strategist at Goldman Sachs, where she and her team advise financial institutions and advisers on asset allocation and portfolio strategy.
If you ask a U.K. financial advisor whether he or should would invest primarily in Italian stocks and bonds, the answer is always the same. No way! Ask the same question in Italy and the answer is usually, Si, certo!
Why? The answer is a widely documented bias in the way people invest. Investors often favor familiar, local markets, which they deem to be less risky even if they are not. This “familiarity bias” turns out itself to be quite risky. It can create large, unintended risk concentrations. Even professional investors are vulnerable.
Another way we see familiarity bias at play is with gold. While its cultural and historical familiarity make it seem safe, its long-term volatility can be higher than that of emerging market equities, and the ownership experience is hardly serene.
Source: GSAM Strategic Advisory Solutions. For illustrative purposes only. Study as of Q4 2018. Diversification does not protect an investor from market risk and does not ensure a profit. Please see additional disclosures. Past performance does not guarantee future results, which may vary.
A key advisor value-add is disentangling this confusion between familiarity and financial risk. Here are two key ways in which we as portfolio strategists surmount familiarity bias in the pursuit of the best outcome for clients.
Firstly, our strategic allocation to UK equities is market-cap weighted at around 7% of our global developed equities. Market cap is our “neutral” because it reflects the aggregate opinions of market participants voting with their dollars, yen, pounds, and euros about where value lies in the global developed equity markets. In contrast, it is common to see UK investors and UK-marketed multi-asset funds with 50% allocations to UK equity. Often these UK equity overweights were funded out of US Equity, highlighting the opportunity cost. If an advisor or fund family does choose adopt a home country overweight, it should be an active choice considered alongside other active choices, such as “should we use liquid alternative strategies?”
Secondly, a common unintentional consequence of a familiarity bias is the underutilization of the huge, relevant, diversifying asset classes we use in our asset allocations, below. Notice how global equities’ familiarity disguises the fact that they are among the highest-risk investments in the chart of returngenerating asset classes. Conversely, daily liquid alternatives are less known to the investor on the street, but their financial risk is relatively low among the return-generating asset classes.
Annualized Volatility: January 1997 to June 2018
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Study as of June 2018. *The Combined Satellites portfolio is made up of the following: 25.7% Emerging Market Equity, 15.5% Global Developed Small Cap, 14.2% Global High Yield, 14.1% Emerging Market Debt, 18.0% Global Real Estate, 8.2% Emerging Market Local Debt and 4.3% Global Infrastructure. **The Combined Satellites w Daily Liquid Alternatives portfolio is made up of the following: 27.8% Daily Liquid Alternatives, 18.6% Emerging Market Equity, 11.2% Global Developed Small Cap, 10.3% Global High Yield, 10.2% Emerging Market Debt, 13.0% Global Real Estate, 5.9% Emerging Market Local Debt and 3.1% Global Infrastructure.Source: GSAM Strategic Advisory Solutions, Bloomberg, HFR Database © HFR, Inc. 2018, www.hedgefundresearch.com. Time period of January 1997 through June 2018 is chosen due to the common inception date of indies used. Data based on monthly (left chart) and daily (right charts) benchmark index returns. Volatility numbers are based on the following indices: MSCI World, MSCI Emerging Markets, FTSE/NAREIT Global, S&P Developed Small Cap, S&P Global Infrastructure, Barclays Global High Yield Index, JPM EMBI Global Diversified, JPM GBI EM Global Diversified, HFRI FoF (left chart). These performance results are backtested based on an analysis of past market data with the benefit of hindsight, do not reflect the performance of any GSAM product and are being shown for informational purposes only. Diversification does not protect an investor from market risk and does not ensure a profit. Please see additional disclosures. Past performance does not guarantee future results, which may vary.
We quantify the reward of overcoming familiarity in these two ways by considering two £1M balanced asset allocations: a traditional one with 30% in UK equities alone and no green and purple diversifiers from the chart above, and a diversified one with no home country bias and 50% green and purple diversifiers. The more diversified asset allocation accumulated £452k more than the traditional portfolio over 10 years (median using data since 2001).
As financial professionals, we have both the expertise and the duty to help clients overcome behavioural biases that may erode their investment success. We at GSAM look beyond the familiarity blinders in two key ways – our market-cap strategic home country equity allocation, and our significant diversification into less-owned but potentially lucrative asset classes. This philosophy is evident in our multi-asset fund range, which is accessible on platforms and via the In Partnership model portfolios.
Appendix
THIS MATERIAL DOES NOT CONSTITUTE AN OFFER OR SOLICITATION IN ANY JURISDICTION WHERE OR TO ANY PERSON TO WHOM IT WOULD BE UNAUTHORIZED OR UNLAWFUL TO DO SO. Opinions expressed are current opinions as of the date appearing in this material only. Prospective investors should inform themselves as to any applicable legal requirements and taxation and exchange control regulations in the countries of their citizenship, residence or domicile which might be relevant.
Indices are unmanaged. The figures for the index reflect the reinvestment of all income or dividends, as applicable, but do not reflect the deduction of any fees or expenses which would reduce returns. Investors cannot invest directly in indices.
The indices referenced herein have been selected because they are well known, easily recognized by investors, and reflect those indices that the Investment Manager believes, in part based on industry practice, provide a suitable benchmark against which to evaluate the investment or broader market described herein. The exclusion of “failed” or closed hedge funds may mean that each index overstates the performance of hedge funds generally.
For illustrative purposes only. Performance results vary depending on the client’s investment goals, objectives, and constraints. There can be no assurance that the same or similar results to those presented above can or will be achieved.
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