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Familiarity Can Breed Bad Investment Decisions

Use this screen to ensure local companies are solid investments and not behavioral-finance traps.

Mike Taggart, 10/27/2009

When considering stocks to invest in, many investors gravitate toward well-known companies. Whether blue-chip stocks, longtime favorites, or companies that are often in the news, there seems to be something inherently comfortable about investing in a well-known stock. However, this comfort can be at best superficial and at worst catastrophic to portfolio performance. The reason behind the comfort is what's known as the illusion of knowledge.

Most of us know someone who has won a bet on a sporting event after basing his decision on nothing more than the teams' colors. This goes against our intuition. How can such a basis for decision-making beat out other bettors who are well-schooled and more knowledgeable about the sport? It's not simply luck. It's that our intuition can fool us. The illusion of knowledge tells us that having more information about something, like a stock or a publicly traded company, will increase our predictive accuracy about future events. Studies have shown, however, that more information can actually decrease predictive accuracy and, simultaneously, increase our confidence. In other words, I think I know more about something than I actually do, so I believe that I can more accurately predict future events around this subject and I am extremely confident in my belief.

How does this fallacy appear in investing? One example could be placing stocks of local companies in client portfolios. After all, they are local companies. We read about them in the local press daily. We know people, maybe even executives, who work at the firm. Maybe a client works there or has friends or family who do. We seemingly know how well the firm is performing by collecting information from the newspapers or from social encounters. Such methods of collecting information for an investment can lead to anecdotal bias. (We collect a few anecdotes about a firm and extrapolate that evidence onto a broader frame, not understanding the missing pieces of our knowledge.)

At Morningstar, we provide equity research coverage on about 2,000 companies. As stock analysts, we are not immune to behavioral finance issues. In fact, we deal with them everyday. Our awareness, however, has led us to certain processes in our routines to ensure that we are not succumbing to biases. Performing scenario analysis on every stock we cover, for example, forces us to take a broad view of likely outcomes. And while we do speak with company management teams, we curb the anecdotal bias by corroborating data against regulatory filings and other management teams' comments within the same industry. Battling our own behavioral biases is tough work, but we guard against it vigilantly.

So how can advisors ensure that local firms within their clients' portfolios are actually solid investments and not traps fraught with behavioral-finance risk? One way is to screen for local companies to see how they stack up. (This screen can be done in Morningstar Advisor Workstation.)

State of Domicile = Illinois

For this issue's screen, we first home in on companies that are based in our state of Illinois. Morningstar's screeners allows you to screen for any state and many countries. In August, our screen resulted in 272 publicly traded companies that are based in Illinois. These firms range in size from global pharmaceutical behemoth Abbott Laboratories ABT to micro-cap Svi Media SVIA, which trades for a penny on the Pink Sheets. Already we can see that not all local firms are created equal.

And Economic Moat = Narrow

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