Despite expanding opportunities for investors to diversify globally, people have a natural tendency to focus on their home markets and companies, a phenomenon known as “home country bias.” As an investment management firm that strongly believes in global diversification, we view this home bias as risky. Why?
Because past positive investment returns in a certain country or sector are not necessarily indicative of positive future returns, yet many investors continue to use this type of inductive reasoning to guide their investment decisions.
The problem with induction
Scottish philosopher David Hume’s problem with induction is that we are not justified in making any inductive, or empirical, judgments about the world. Inductive reasoning is where conclusions are built based on experimental or factual evidence. This is how science works. If you do a bunch of experiments and always get the same result then you can generally conclude that it will continue to work that way going forward. You don’t actually have to know why it works, just that it does.
But here’s Hume’s – and our – problem with induction: we can never really be sure. Our conclusions are only ever provisional at best. And this has significant implications for investment risk management.
A cautionary turkey tale
In Nassim Nicholas Taleb’s 2007 book, The Black Swan, he recounts the allegory of a turkey that is fed by a farmer every morning for 1,000 days.
Eventually the turkey comes to expect that every visit from the farmer simply means more good food. It seems logical; this is all that has ever happened to the turkey, so he figures that’s all that can and will ever happen.
But then Day 1,001 arrives. It is two days before Thanksgiving, and when the farmer shows up this time, he is bearing not food, but an axe. The turkey learns very quickly that his expectations were catastrophically off the mark.
This happens in investing, too. Not that we get our heads cut off, but that things that we’ve become very accustomed to through experience can suddenly change.
The invention of horizontal multistage fracking is an example of this. It completely changed the game in natural gas, and it may also change the game in oil. Or, from a Canadian perspective, think back to the overnight changes made to the income trust market.
So how do you avoid becoming a turkey? The first line of defense is to do your homework. In particular, ask a lot of questions. If you’re a turkey, why is the farmer sharpening his axe? If you’re an investor, why are insiders selling? Why are inventories piling up? Why are unit sales slowing down?
But there are many risks that you still won’t be able to see coming, and the only real defense against them is diversification. Yet diversification is tricky. You have to look for systemic or inconspicuous risks.
For example, Canada is a highly non-diversified market, even though we have representation in all ten sectors, and we have hundreds of companies in many different industries. It is highly non-diversified because most of these companies relate to natural resources in some way or another. This means that if your equity portfolio is 100% in Canadian equities, you run a high risk of a downside surprise. It’s been a great ten years, but like the turkey in Taleb’s tale, that inductive evidence doesn’t preclude a nasty shock.
We’re not saying that the resource run is over, but that doesn’t mean we want to bet our portfolio on it. And neither should you.That’s why we suggest investing globally. Not only does it provide risk reduction, it also provides more opportunities to find boring, money-making companies. So don’t be a turkey: make the world your investment arena.