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Winter 2004 CalBusiness  
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International Markets Offer Lessons to US Investors

By Diane Anderson

It turns out that it really is a small world after all — investors the world over follow similar investing patterns, often to the detriment of their portfolios. This spring Mark Seasholes, an assistant professor of finance at Haas, presented findings from an ongoing study that examines individual stock account data from outside the United States.

"We need to look at overseas markets to confirm or expand how we think of stocks," explains Seasholes. "A lot of what we think is exclusively based on US data. The US is a huge, liquid market, and we consider it to be well-developed and regulated.

But other markets might offer new insights because they have different rules or simpler markets." One region Seasholes focused on was the People’s Republic of China (PRC).

Seasholes found that the stock under-diversification problem plagues more than just individual investors in the United States. His PRC data includes more than 90,000 investor accounts trading in approximately 1,000 stocks on two stock exchanges: the Shenzhen Stock Exchange and the Shanghai Stock Exchange. The average investor there holds three stocks (compared with four in the United States). But investors "tilt" their portfolios, putting 33 percent of their money in stocks with headquarters in their own region, which is called "home bias." They also have a "cultural affinity bias," which means investors tend to hold stocks of companies with headquarters in the province where they were born.

"In the United States, we see similar behavior," says Seasholes. "For example, in the Bay Area, we hold Silicon Valley stocks because we are exposed to those companies and people feel a kinship with those companies." Basically, where investors were born and where they currently live determine their preconceptions about a company. "News about new products or earnings may be the same across the country, but your ‘prior beliefs’ bias you." Investment strategies, such as deciding what to trade and when to trade it, are not as objective as they might be.

Investors should try to avoid such biases and do thorough research before deciding to trade, says Seasholes. And buying shouldn't be based simply on which companies you have heard of or which stock names you recognize.

In China, investors also tend to hold stocks that trade on the exchange near where they live. This is not seen in the United States because of the market structure (i.e., China has different listing rules than America does.) A company based in Beijing may operate all over the PRC, but the stock can be listed on only one exchange — either the SSE (Shanghai Stock Exchange) or the SZSE (Shenzhen Stock Exchange). An investor is likely to invest in stocks listed on the exchange near where the investor lives.

Seasholes’advice? Again, be sure to diversify. "We all tend to under-diversify our portfolios. We learned this the hard way with Enron. The best advice for investors is to put your money in a well-diversified fund. Funds that track the S&P 500 are popular choices," says Seasholes, because they contain a mix of all stocks: automobile manufacturers, utilities, high-tech companies, biotech, etc.

Seasholes also warns of "loss aversion." For example, consider an investor who holds three stocks: one that is trading above the original purchase price, one at the purchase price, and one much lower. Naive investors tend to sell the stock that is trading above the original purchase price and recognize a capital gain. Recognizing the capital gain makes the investor feel good and confirms his or her feeling that they have chosen good stocks. Unfortunately, investors tend to hold onto stocks that are trading below the purchase price. Investors are very reluctant to sell at a loss and (often) mistakenly think that they’ll make up the loss over time by holding on to the loser stock.

"This psychological phenomenon is well-documented in the United States by Professor Terry Odean (also at Haas)," says Seasholes. "But it appears to be a human characteristic; an innate trait, not just a quirk of the US market."

Do investors need to learn to escape this loss-aversion bias? "Yes," Seasholes says emphatically, and he offers hope that it’s possible. "In the PRC, we have seen evidence that investors can train themselves to react less in a knee-jerk manner." As an individual has more experience trading stocks, the individual tends to be able to recognize losses and get out of bad investments.

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Mark Seasholes

Mark Seasholes, assistant professor in the Finance Group.
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