iShares: An Investment Lesson in Failed New Year’s Resolution

ETF Trends

It’s 24 days into 2013. So, how well are you sticking to that New Year’s resolution to go to the gym?

It’s no secret that one of the most common resolutions is to exercise more. Gyms regularly take advantage of this trend with membership discounts and promotions at the start of every year. But we’re all very familiar with stories on just how short-lived these resolutions can be, with the Marist annual poll showing over 40% of Americans answering “no” to having kept to their 2012 resolution even part of the year.

Why, then, do we pay for monthly gym memberships when many of us know that it is unlikely that we will keep our resolutions? Part of the problem, according to research by psychologists and behavioral economists, is overconfidence in our ability to resist temptations of all kinds, including the temptation to slack off and skip the gym [1]. If I tell myself that I will actually go the gym once a week all year, then a membership is very appealing. I have assigned a higher weight to my own assessment of my ability to keep to my plans than the evidence from my own past and the well-publicized evidence that a large proportion of people fail to keep to their gym-attendance plans. In short, I’m overconfident in my ability to keep hitting the gym all year long.

As is the case with a wide range of behavioral research, these findings can be applied to finance and asset allocation. One of the most interesting applications is the idea that overconfidence may partly explain “home bias.” This is the tendency that many investors have to allocate larger proportions of their portfolio toward securities in their home country, forgoing the benefits of a well-diversified global portfolio [2]. In this case, an investor’s perceived familiarity with “local” companies or investments leads to over-confidence in one’s ability to invest in those companies compared with unfamiliar foreign companies. This leads to a willingness by investors to ignore the diversification benefits of a global portfolio because it may be perceived as being composed of unfamiliar or unknown companies and investments. [Where to Invest in Europe ETFs Now]

This year, instead of a going-to-the-gym resolution, consider a resolution to increase the diversification in your portfolio. If you do hold a disproportionate share of your portfolio in local assets, consider diversifying your portfolio into international markets that may help to offset the slow-growth scenario we are likely to see in the United States in 2013. These include emerging markets with higher economic growth prospects and lower correlation to the U.S. market, and where valuations are still attractive as compared with developed market valuations. [Two Reasons to Stick with Emerging Market ETFs]

And come February, you also might consider cancelling that gym membership if your overconfidence got the best of you.

Daniel Morillo, PhD, is the iShares Head of Investment Researc.

[1] See, for example:
“Paying not to go to the gym” by Stefano DellaVigna and Ulrike Malmendier.
“Whatever is Willed Will Be: A Temporal Asymmetry in Attributions to Will” by Erik Helzer and Thomas Gilovich

[2] See, for example, “Home Sweet Home: Home Bias and International Diversification among Individual Investors” by Anders Karlsson and Lars Norden

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