Morningstar Advisor - October/November 2009 - 64

Screens Familiarity Can Breed Bad Investment Decisions By Mike Taggart Use this screen to ensure local companies are solid investments and not behavioral-finance traps. 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 64 Morningstar Advisor October/November 2009

Morningstar Advisor - October/November 2009

Table of Contents for the Digital Edition of Morningstar Advisor - October/November 2009

Morningstar Advisor - October/November 2009
Contents
New on MorningstarAdvisor.com
Letter from the Editor
Contributors
How Do You Use Behavioral Finance in Your Practice?
Investing in the Moment
Investment Briefs
How the Best Large-Cap Managers Rise Above the Rest
Don’t Give Up on Stocks Just Yet
Makeup of the Mind
A Top-Down Approach
In Practice: Patterns of Investor Irrationality
A Call for Nudges
The Furious Comeback of Emerging Markets
Junk-Bond Pioneer
Four Picks for the Present
Consumer Staples Hold Up in the Kitchen
Familiarity Can Breed Bad Investment Decisions
Leave the ‘Junk Rally’ Behind and Look for Quality at a Reasonable Price
Mutual Fund Analyst Picks
50 Most Popular Equity ETFs
Undervalued Stocks
New at Morningstar
Meet the New Boss, Same (School) as the Old Boss
Morningstar Advisor - October/November 2009 - Morningstar Advisor - October/November 2009
Morningstar Advisor - October/November 2009 - Cover2
Morningstar Advisor - October/November 2009 - 1
Morningstar Advisor - October/November 2009 - 2
Morningstar Advisor - October/November 2009 - Contents
Morningstar Advisor - October/November 2009 - 4
Morningstar Advisor - October/November 2009 - 5
Morningstar Advisor - October/November 2009 - New on MorningstarAdvisor.com
Morningstar Advisor - October/November 2009 - 7
Morningstar Advisor - October/November 2009 - 8
Morningstar Advisor - October/November 2009 - Letter from the Editor
Morningstar Advisor - October/November 2009 - Contributors
Morningstar Advisor - October/November 2009 - 11
Morningstar Advisor - October/November 2009 - How Do You Use Behavioral Finance in Your Practice?
Morningstar Advisor - October/November 2009 - 13
Morningstar Advisor - October/November 2009 - 14
Morningstar Advisor - October/November 2009 - Investing in the Moment
Morningstar Advisor - October/November 2009 - 16
Morningstar Advisor - October/November 2009 - 17
Morningstar Advisor - October/November 2009 - 18
Morningstar Advisor - October/November 2009 - Investment Briefs
Morningstar Advisor - October/November 2009 - 20
Morningstar Advisor - October/November 2009 - 21
Morningstar Advisor - October/November 2009 - How the Best Large-Cap Managers Rise Above the Rest
Morningstar Advisor - October/November 2009 - 23
Morningstar Advisor - October/November 2009 - 24
Morningstar Advisor - October/November 2009 - 25
Morningstar Advisor - October/November 2009 - 26
Morningstar Advisor - October/November 2009 - Don’t Give Up on Stocks Just Yet
Morningstar Advisor - October/November 2009 - 28
Morningstar Advisor - October/November 2009 - 29
Morningstar Advisor - October/November 2009 - Makeup of the Mind
Morningstar Advisor - October/November 2009 - 31
Morningstar Advisor - October/November 2009 - A Top-Down Approach
Morningstar Advisor - October/November 2009 - 33
Morningstar Advisor - October/November 2009 - 34
Morningstar Advisor - October/November 2009 - 35
Morningstar Advisor - October/November 2009 - 36
Morningstar Advisor - October/November 2009 - 37
Morningstar Advisor - October/November 2009 - 38
Morningstar Advisor - October/November 2009 - 39
Morningstar Advisor - October/November 2009 - In Practice: Patterns of Investor Irrationality
Morningstar Advisor - October/November 2009 - 41
Morningstar Advisor - October/November 2009 - 42
Morningstar Advisor - October/November 2009 - A Call for Nudges
Morningstar Advisor - October/November 2009 - 44
Morningstar Advisor - October/November 2009 - 45
Morningstar Advisor - October/November 2009 - 46
Morningstar Advisor - October/November 2009 - 47
Morningstar Advisor - October/November 2009 - The Furious Comeback of Emerging Markets
Morningstar Advisor - October/November 2009 - 49
Morningstar Advisor - October/November 2009 - 50
Morningstar Advisor - October/November 2009 - 51
Morningstar Advisor - October/November 2009 - 52
Morningstar Advisor - October/November 2009 - 53
Morningstar Advisor - October/November 2009 - 54
Morningstar Advisor - October/November 2009 - Junk-Bond Pioneer
Morningstar Advisor - October/November 2009 - 56
Morningstar Advisor - October/November 2009 - 57
Morningstar Advisor - October/November 2009 - Four Picks for the Present
Morningstar Advisor - October/November 2009 - 59
Morningstar Advisor - October/November 2009 - 60
Morningstar Advisor - October/November 2009 - Consumer Staples Hold Up in the Kitchen
Morningstar Advisor - October/November 2009 - 62
Morningstar Advisor - October/November 2009 - 63
Morningstar Advisor - October/November 2009 - Familiarity Can Breed Bad Investment Decisions
Morningstar Advisor - October/November 2009 - 65
Morningstar Advisor - October/November 2009 - Leave the ‘Junk Rally’ Behind and Look for Quality at a Reasonable Price
Morningstar Advisor - October/November 2009 - 67
Morningstar Advisor - October/November 2009 - Mutual Fund Analyst Picks
Morningstar Advisor - October/November 2009 - 69
Morningstar Advisor - October/November 2009 - 70
Morningstar Advisor - October/November 2009 - 71
Morningstar Advisor - October/November 2009 - 50 Most Popular Equity ETFs
Morningstar Advisor - October/November 2009 - 73
Morningstar Advisor - October/November 2009 - Undervalued Stocks
Morningstar Advisor - October/November 2009 - 75
Morningstar Advisor - October/November 2009 - 76
Morningstar Advisor - October/November 2009 - 77
Morningstar Advisor - October/November 2009 - 78
Morningstar Advisor - October/November 2009 - New at Morningstar
Morningstar Advisor - October/November 2009 - Meet the New Boss, Same (School) as the Old Boss
Morningstar Advisor - October/November 2009 - Cover3
Morningstar Advisor - October/November 2009 - Cover4
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