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Financial Decoder: Season 6 Episode 2

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How Does Familiarity Bias Affect Your Investments?

Choosing investments that are familiar can be comforting, but how can you choose more objectively?

It makes sense to have a certain level of familiarity with the securities we put in our portfolio. But just investing in familiar securities and products can blind us to other options that might benefit us.

In this episode, Mark Riepe explores the “home bias”—or the tendency to invest in stocks from one’s home country—with Schwab’s Chief Global Investment Strategist Jeffrey Kleintop. They discuss how global companies often have a similar footprint, how some countries act as proxies for certain sectors, and ways to avoid the home bias.

Next, Mark speaks with Cooper Howard, managing director for fixed income strategy at the Schwab Center for Financial Research. Cooper and Mark discuss how investors tend to over-invest in municipal bonds from their home state, or from bond issuers with which they are familiar. This is a tricky bias in the muni market because there are some tax incentives to invest in munis from one’s home state. Cooper also explains some often-misunderstood characteristics of muni bonds and the bond markets.

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Financial Decoder is an original podcast from Charles Schwab.

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Click to show the transcript

MARK RIEPE: Imagine this: You wake up in the morning and you don’t feel well. You go back to bed for an extra hour hoping that a little extra sleep will do the trick.

But an hour later you’re still not feeling better. You drag yourself out of bed, rummage through the shelf where you keep over-the-counter medicines, and see that nothing is remotely close to what you need.

You go to the drugstore looking for something that will help. How do you decide what to buy?

According to one study,[1] people tend to ask for medicine they’re familiar with. If they have an upset stomach today, and in the past a certain antacid has worked, they’ll take that same familiar antacid.

This tendency to stick with what we know has a name: It’s called the familiarity heuristic.

Like many heuristics we’ve talked about before, there’s a lot to be said for thinking this way.

After all, if a strategy has worked in the past, it makes sense to not overanalyze and instead default to the tried and true method if you confront a similar situation in the future.

However, sticking with the familiar has a downside. The study we mentioned earlier went a step further and discovered patients will ask for a name brand medicine that they’ve heard of—even if they’ve never taken it and a less-expensive generic is available. In other words, our preference for the familiar can also be driven not only by our personal experience, but what we’ve heard.

It can also, at times, lead to a worse choice.

I’m Mark Riepe, and this is Financial Decoder—an original podcast from Charles Schwab.

It’s a show about financial decision-making and the cognitive and emotional biases that can get in our way.

Our reliance on the familiar and the subtle costs associated with it shows up everywhere. We might have a favorite dish we automatically order every time we go to a certain restaurant. That’s fine, of course, but it prevents us from trying other menu items we might like even better. When it comes to exercise, we may prefer doing a certain exercise repeatedly. If we do that, though, eventually our bodies adapt, and the benefits decrease. We expend all that energy and only gain a fraction as much strength or stamina as we did at first. That’s why cross-training is so effective.

It’s no surprise, then, that we prefer the familiar when it comes to building our investment portfolios as well.

But just like in those examples, there are consequences to that decision.

Some of the oldest studies on this topic found that investors tend to overly concentrate their stock portfolios in companies with which they have some familiarity. The classic example involves 401(k) plan participants investing too much of their accounts into the stocks of their employers. Back in the days when the telephone industry was far more fragmented than it is today, one study found that residents in 49 out of the 50 states held more shares in the telephone company closest to them than in telephone companies further away.[2]

Like so many biases we cover on the show, this isn’t solely a U.S. phenomenon. Similar behavior has been observed in China, Finland, and Sweden. We’ve covered the importance of not becoming too dependent on one stock in other episodes. Our episodes on how to invest in your 401(k) plan and how to handle employee equity compensation are good examples of this phenomenon. On this episode, we’re going in a different direction.

First, I’m going to speak with Jeffrey Kleintop. Jeff is a senior vice president and chief global investment strategist at Schwab. He analyzes and discusses international markets, trends, and events to help investors understand their significance and financial implications. He appears frequently on CNBC, Bloomberg TV, and CNN and is often quoted in The Wall Street Journal, Barron’s, and the Financial Times.

I’m going to speak to Jeff about what’s called the “home bias.” This is the tendency for investors to overly prefer the stocks of companies in their home country.

After Jeff, I’ll be speaking with Cooper Howard. He’s a director of fixed income strategy for the Schwab Center for Financial Research. He’s an expert on fixed income markets—especially the municipal bond market—and has been quoted in several financial publications, including The New York Times, Bloomberg, and The Bond Buyer.

I’m speaking with Cooper about municipal bond investing and the tendency for bond investors to prefer the bonds of issuers from their own state. This is a tricky topic because the U.S. tax code creates incentives for investors to do this. Nevertheless, it’s possible for investors to go too far and inject unnecessary risk into their portfolios.

Joining me now is Jeffrey Kleintop. Thanks for being here today, Jeff.

JEFFREY KLEINTOP: Hi, Mark. It’s great to be with you.

MARK: Jeff, the focus of this episode is the familiarity bias. Certainly, when it comes to investing overseas or investing outside the United States, a lot of times this is referred to as the home bias. So why don’t we just start at the beginning? What is the home bias?

JEFF: When investors talk about the stock market, they’re most often referring to an index that tracks stocks only in their home country, and that home bias is evident when it comes to the makeup of their portfolios, as well. Investors tend to hold mostly domestic stocks, even when their country is the home of only a small portion of the world’s stock market.

MARK: Jeff, when we think about a lot of these biases, a lot of times we’ll focus in on U.S. data and the behavior of U.S. investors, but we’ll often note that … for many of these biases, they’re really human biases, and they affect all investors. So is that the case with the home bias? Is this just something that’s peculiar to the United States, or is this something that affects all investors around the world?

JEFF: It’s true everywhere. U.S.-based investors seem to believe they’re sufficiently diversified with about 75% of their equity investments inside their country borders, according to IMF data, as do those that live in Japan, or Spain, or dozens of other countries, even Brazil and South Korea. These investors with a very large home bias may not be nearly as diversified as they think they are.

MARK: Jeff, why is home bias typically thought of as a bad thing, or at least something to be avoided or mitigated as much as possible?

JEFF: No one country offers full global stock market exposure. In fact, it may be surprising how closely the stock markets of some major countries perform like a single sector of the global stock market, and this illustrates the lack of diversification inherent in having a portfolio with a large home bias, even for those investors that live in a major country. Let me give you some examples.

The entire Canadian stock market performs much like the energy sector, and that’s despite the fact that energy isn’t even the biggest sector of Canada’s stock market. The Canadian economy is more reliant than most on natural resources, where even the banks are tied to the commodity cycle. Canadian investors’ home bias, with more than half of their portfolios invested in the domestic stock market, makes sense only if Canadians think exposure to the energy sector should make up most of their portfolio.

In Japan, the stock market closely tracks the global financial sector. The financial sector isn’t the largest in Japan’s stock market, but the influence of global financial conditions on all types of Japanese companies is evident in their performance. Rather than being broadly diversified, Japanese investors’ home bias means they have most of their portfolios linked to the moves in the global financial sector.

Now, in the U.S., the largest sector of the stock market seems to drive overall performance, tech stocks. Overall, the U.S. acts like one big tech fund. 

And I could go on and on, but the point is that this goes a long way to explain the differences in stock market performance by country, regardless of politics or economics. You know, of the three stock markets I mentioned, the United States has performed the best over the last 10 years as it tracked the run-up in the world tech sector. The U.S. was followed by Japan, fueled by the world financial sector, which posted similar gains to Japan. And Canada was the weakest, falling 1% over the last 10 years, held back by the poor performance of the world energy sector, which also posted a loss over that 10-year period. And that, by the way, is the reverse of the prior 10-year period in the early 2000s, when energy and Canadian stocks led the world’s markets as oil prices soared.

So, Mark, global diversification can ensure that you always have some exposure to whatever sector is performing the best. Of course, it can also seem to be a drag on your portfolio when one sector sharply outperforms the others for an extended period, as it has with tech in U.S. stocks. But I think we would all agree that only having exposure to just one sector probably isn’t the smartest way to invest.

MARK: I think that Japanese example is particularly interesting because you’re talking about the third largest economy in the world, but given some of the data you were just suggesting, it’s just another piece of evidence that the stock market is not the economy.

JEFF: Exactly.

MARK: Jeff, people are … I think one of the roots, really, to the familiarity bias is that, you know, people like to stick with what makes them comfortable. And when they start looking outside their borders when it comes to investing, a lot of that stuff makes them uncomfortable because it’s not familiar. But I’ve heard you talk about many times the fact that many of these foreign companies, people are more familiar with them than they may realize.

JEFF: Yeah, that’s true. You know, big companies in the same sector or industry typically serve the same global customer base, and they’re familiar to consumers wherever they live. For example, Nestle, a Swiss company, we all know, is the biggest stock in the MSCI Europe Index. Nestle and Coca-Cola have the same geographic distribution of sales by region within a few percentage points. They both get about a third of their revenue from the U.S., about 20% from the rest of the Americas, 20 to 25% from Europe, and a similar amount from Asia, and about 5 to 10% from Africa. I mean, sure, they’re different brands, but they sell beverages and snacks to the same folks around the world. And, clearly, the same could be said for Japan’s biggest stock, Toyota, compared to Ford in the U.S. They sell to the same customers. Or even the pharma companies leading the development of a COVID vaccine, like the U.K.’s AstraZeneca and the U.S.’s Pfizer. So they really aren’t that foreign at all.

MARK: Jeff, you can’t really talk about foreign investments without thinking about the impact of currency, so why do currencies matter?

JEFF: If you hold a stock that’s denominated in another currency, you not only experience the change in the stock price in that currency, but also the change in the value of that currency when measuring your portfolio in dollars. The currency can move as much as the stock price, so it’s an important factor to consider. The dollar is the world’s most used currency, but that doesn’t mean its value is stable.

MARK: Jeff, as of the time we’re recording this, it’s widely expected by many that the U.S. dollar will be depreciating against other currencies over time. If that actually comes to pass, is that a positive or is that a negative for foreign stock investments?

JEFF: When the dollar falls, it’s a good thing for U.S.-based investors in international stocks. Here’s an example. In July of this year, European stocks fell 1½%, measured in euros, but because the dollar fell versus the euro by even more than that, European stocks actually posted a gain in dollars of 3½% for the month. That’s a big difference. If the dollar is embarking on a long-term slide, it could act as a consistent boost to the performance of international stocks when measured in dollars.

MARK: Jeff, one podcast episode is not going to cure anyone of the home bias, but it might be able to mitigate some of the effects, at least a little bit. You talk to investors all the time. What are some tips that you have for them to think about when they’re investing so they’re less susceptible to this bias?

JEFF: An investor should have exposure to many different sectors of the stock market. Broad global exposure is needed to achieve this. Even a portfolio that holds Canadian, Japanese, and U.S. stocks may behave as if it only had exposure to three stock market sectors, rather than being more fully diversified across all 11. You know, the benefit of a broad international mutual fund or ETF is that you get exposure to a lot of sectors and stocks. If you were to invest in multiple international ETFs, say, broken down by country, you need to own quite a few of them to be diversified, since Germany acts much like an auto sector ETF, France like an industrial, Denmark like a healthcare ETF, Australia like a mining ETF. But with a broad international fund, you don’t have to worry about balancing those exposures to make sure you don’t have too much in any one of them and overexposed to any one country or industry. Fortunately, as many investors around the world consider reducing their home bias, obtaining global diversification’s never been easier or less expensive. How much exposure outside your home country should you have in your portfolio? Well, that depends on your risk tolerance and time horizon, but it’s clear from the data that most investors can broaden their opportunity set and diversify their portfolios simply by significantly boosting the international portion of their stock portfolios.

MARK: Appreciate that, Jeff. One more question, then I’ll let you go. What’s the … what’s the biggest misconception that you think investors have about overseas markets?

JEFF: It’s probably that focus on politics and economics. You know, history shows us that the markets and economics have more of an influence over political outcomes than the other way around, and the truth is that the fastest growing economy is rarely the best performing stock market for all the reasons we’ve talked about. All this isn’t to suggest that the country a company is based in doesn’t matter. It does. But it matters a lot less than people think it does, and it’s meant less and less as time goes on.

MARK: Jeffrey Kleintop, chief global investment strategist for Schwab. Thanks for your time today.

JEFF: My pleasure. Thanks for having me.

MARK: Cooper, thanks for joining me today. Let’s start at the beginning, and let’s just spend maybe a couple of minutes with some real basic stuff when it comes to municipal bonds. We’ve discussed bonds on the show several times, and one thing that comes through loud and clear in those discussions is that there’s no one bond market. So what is a municipal bond, and why should somebody invest in it?

COOPER HOWARD: You know, really, it’s a bond that’s issued by a city, a state, or a local government. And this can range from anything from a bond that’s backed by the full faith and credit of a state, and that’s known as a general obligation bond, to a bond that’s backed by the revenues from something like a university or your local water and sewer district. Those are known as revenue bonds. And, often, the interest income that they pay is exempt from federal income taxes. And if the issuer is in your home state, it can also be exempt from state income taxes, as well. And because of these tax benefits, they generally pay an interest rate that’s less than other bonds, all things equal.

Now, although the stated yield may be lower than other bonds, the after-tax yield, which is actually the amount that you receive after having to pay taxes, that may be higher, depending on your tax bracket. And this after-tax yield increases as you move into a higher tax bracket. So that makes them an attractive option for high income earners, Mark.

MARK: One more basic question. How do you go about investing in one of these bonds?

COOPER: You know, the most common ways are by buying individual bonds or through a fund, like a mutual fund or an ETF. And the benefit of buying individual bonds is that they usually pay a set coupon amount, and they have a specific maturity date, so that way, you know exactly what you’re going to receive and when you’re going to receive it, barring default. So this can make income planning a little bit easier. Now, the downside is that it’s harder to achieve adequate diversification because you need many different bonds with different credit risks.

Now, the benefit of an ETF or a mutual fund, on the other hand, is that you generally get broad diversification for every dollar that you invested. Also, they may be professionally managed, so you can benefit from a professional money manager making the buy and sell decisions for you. The downside, however, of a mutual fund or an ETF is that there’s usually no set maturity date or no set coupon, so your cash flows can fluctuate.

MARK: Cooper, the premise of this episode is that investors spend too much time only considering investments with which they’re familiar, and that’s a bad thing. But the way you just described that, and at least when it comes to the municipal bond market, there are actually some good reasons because of the Tax Code to pay close attention to bonds issued in your home state. Explain that in a little bit more detail.

COOPER: Yeah, you’re right. There are good reasons to pay attention to bonds issued in your home state because they are exempt from state income taxes, usually. Some are subject to state income taxes, however. But what we’ve found is that investors often purchase only municipal bonds from their home state because they want to avoid having to pay those state income taxes.

MARK: Other than taxes, are there other reasons that create this desire to prefer the bonds of issuers who are, you know, geographically close by?

COOPER: Yeah, there are a couple of different reasons. The first is that there’s a sense of control by purchasing munis from your home state. For example, you’re likely more familiar with a toll road in your hometown versus a toll road on the other side of the country. Also, investors feel like they can get better access to information for issuers that are located close to them. For example, we might be more familiar with the trends in the real estate market in our own city versus elsewhere in the country.

MARK: Those are the advantages. Let’s talk about the disadvantages. What are the kind of the pitfalls, if you will, that come from just sticking with your home state?

COOPER: Yeah, one potential pitfall is that you can potentially earn higher yields by investing in out-of-state municipal bonds, even after having to consider the tax benefits that in-state munis offer.

MARK: As you look at the bond market, then, under what conditions are those higher yields typically available?

COOPER: Usually, you would have to take on a little bit more credit risk. That means moving down in terms of credit rating or investing in a bond that might be a little bit more risky.

MARK: Cooper, where does diversification come into play? I assume that there are some advantages to having issuers in lots of different parts of the country.

COOPER: You’re right. Diversification is an important topic to consider. And in fact, broadening your search criteria to more than just your home state, that can help with diversification. Now, we oftentimes recommend that if you’re investing in individual bonds, you should purchase at least 10 different issuers with differing credit risks. And this can be difficult if you live in a state with a few number of issuers or if many of the issuers in your home state are susceptible to similar economic risks. That could be a benefit of diversifying outside of your home state.

MARK: In the past, we’ve talked about the importance of taking a kind of broad, comprehensive look at your financial situation, taking a broad frame, if you will. In the case of an individual investor, part of their portfolio is their financial assets, of course, but there’s also their human capital, you know, the skills they have that help them generate a paycheck. Is that relevant, as well, when it comes to deciding how to invest in municipal bonds?

COOPER: It is relevant. You want to consider if your human capital and your investment portfolio face similar risks. So, for example, investors should consider if they’re employed in a sector that contributes to a large portion of the state’s overall economy. Now, this is an extreme example, Mark, but nearly 85% of Alaska’s state revenues are supported by oil and gas. So an Alaska resident who works in the oil and gas industry, they’re taking on added and arguably unnecessary risk because if there’s a slowdown in the oil and gas industry, it could negatively impact both their employment status, while at the same time negatively impacting their municipal bond holdings.

MARK: So, Cooper, as you think about both the advantages and the disadvantages and the fact that we’ve got, you know, 50 different states and various territories, given all of that, are there any situations where just sticking with your home state makes sense?

COOPER: There are some reasons that you should stick within your home state, and one of the first factors and probably the most obvious factor is your state income tax rate. So if you’re in a state with a high state income tax rate, that’s when it could make sense to stick in-state. For example, California’s top tax rate is 13.3%, and New York’s is 10.75%, so there’s a tax benefit to sticking in-state for those residents. Whereas Florida and Texas, they don’t have state income tax rates, so there’s no tax benefit to sticking in-state.

The second factor you want to consider is are you in a state with a large number of issuers? For example, bonds from California, New York, Texas, just those three states, they account for about 40% of all the issuers in the Bloomberg Barclays Municipal Bond Index, which is a commonly tracked muni index. Now, investors in other states, they have a more difficult time of achieving adequate diversification because there might not be enough issuers.

Now, if we sum up all of the factors, Mark, the only states that we recommend an in-state solution are New York and California. Generally, investors in all other states should diversify nationally.

MARK: OK, Cooper, so I hear you, I think it makes sense to diversify nationally, but I hear about certain states that have a lot of financial difficulties. Does it make sense to diversify nationally, but just entirely avoid certain states? Is that a strategy you would recommend?

COOPER: No, that’s not a strategy that we’d recommend. And this goes back to one of the points that you made early on in this podcast. There isn’t one single municipal bond market, and there isn’t one single municipal bond issuer. And, in fact, the muni market is nearly $3.7 trillion in size with many different issuers, and each issuer is backed by their own different revenues and has their own different expenses, and those revenues and expenses can be separate from the state’s fiscal situation, even though that issuer may be located in that state.

Take, for example, school districts in California. Those bonds are usually backed by the property taxes of the properties in that district. Now, school districts in California, they do receive some funding from the state, but often, that money to pay debt service is separate from the state funding. That money to pay debt service comes from the property taxes, not the state.

Now, one extreme example we hear from clients often, Mark, is that they want to avoid all bonds from an issuer in Illinois because it’s the lowest-rated state. However, there are some cities and areas on the northern suburbs of Chicago that are actually very highly rated.

MARK: Cooper, every time I do a client event, if the topic of municipal bonds comes up, somebody is going to ask one of two questions. The first question is what about the unfunded pension liabilities? In other words, how can municipalities and states pay off bond holders when they haven’t set aside enough money to pay off their pensioners?

COOPER: Our view on unfunded pension liabilities is that they aren’t a risk to the broad municipal bond market. But there are, obviously, some issuers that do struggle with high unfunded pension liabilities, and that burden and the ability to address those challenges, that varies widely. And this, again, goes back to the idea that there’s no single issuer in the muni bond market. So stories that say things like there’s a ticking time bomb in the muni market, that just oversimplifies the issue. And, in fact, most municipalities are able to regularly fund their pension expenses without that crowding out debt service. And, in fact, a large majority are generating enough revenue to make current pension payments. And many that are struggling with it, they’ve also taken steps to address those future shortfalls, such as increasing contributions or changing how those retirement benefits are calculated. And most state and local governments, Mark, they haven’t set aside all of the assets required to meet 100% of the needs of the future retirees. And not having a fully funded pension plan, that’s not an immediate concern in our view. And, on average, states have set aside about 68 cents per dollar, according to Standard & Poor’s, and this is known as a funded ratio. And of course, some plans are better funded than others, though.

MARK: Cooper, go into that funded ratio in more detail. What does that mean, 68% of what, exactly?

COOPER: You know, the funded ratio is, essentially, the projected amount of money that will be available to meet the future needs of retirees relative to what those needs are projected to be. Now, Mark, when a municipality has a pension plan, usually both the employer and the employees are required to regularly contribute to that plan, and this money is then invested. And so how much that money is expected to grow to is compared to how much those employees are expected to need when they retire, and this comparison between the two is the funded ratio. For example, if that money is expected to grow to $70, but it’s expected that they’re going to need $100, that funded ratio is 70%, or 70 divided by 100.

MARK: Cooper, where does debt service rank in terms of size when compared to the other payments a municipality or a state must make?

COOPER: You know, that’s a good question because payments to pensions, they do have to compete with other expenses, such as operations and debt service. Now, the good news is that debt service is generally a low portion of state revenues, so payments to pension plans aren’t crowding out debt service.

MARK: Yeah, this is a great example. At least as of the time we’re recording this, interest rates are so low, that’s really benefiting all borrowers because the interest expense isn’t nearly as high as it was maybe a few years ago.

COOPER: Correct.

MARK: Cooper, the second question I always get at client events is what about the coronavirus? Many states and local governments are facing severe declines in revenues. How will the pandemic impact their ability to issue bonds and pay off those bonds?

COOPER: That’s another good question, and they are facing severe declines in revenues, and it’s estimated that state and local governments are facing a combined shortfall of between 200 billion and 400 billion over the next two years. Now, Mark, while that number is staggering, we don’t think that it will lead to broad defaults in the municipal bond market. And the reason is that most state and local governments operate on a balanced budget requirement, so they have to make sure that revenues match expenses. And given the severe declines in revenues, they will likely have to take steps, such as cutting expenses or raising revenues, like raising taxes or tapping into rainy day funds. One of the expenses that we don’t expect state and local governments to cut, though, is debt service.

MARK: Another source of funds, of course, is government aid, and that’s why I think you’re hearing so much interest on the part of state and local governments in getting various forms of fiscal stimulus passed.

Cooper, when the lockdowns began, in how good a shape financially were states, on average? In other words, were they in poor shape, or were they in good shape, which makes it easier to weather these kinds of storms?

COOPER: In aggregate, most states actually entered into this crisis in a fairly solid financial situation, and they actually benefited from the long and slow economic recovery, and they took steps to shore up their finances. For example, the median state rainy day fund—that reached over 7.6% of general fund expenditures in fiscal year 2019. So they did have some money set aside to tap into if they faced a severe decline in revenues like they are now.

MARK: Cooper, can you talk a little bit about the legal protections that bond holders have and whether investors should take comfort from those protections if they’re holding bonds issued by states that are in worse financial condition?

COOPER: Yeah, the legal protections are another reason why we don’t expect broad defaults in the municipal bond market because these legal protections are afforded to bond holders, and they’re generally not afforded to other types of expenses. For example, the state of Illinois is required every year to set aside the next year’s worth of principal payments on bonds and separate those funds from other monies to pay for other expenses. Or in the case of California, debt service is actually the second highest priority of payments for the state, and that’s only behind payments to education.

MARK: Cooper, let’s switch gears a little bit and talk about how an investor should be making decisions. It can be difficult for investors to analyze all the different issuers out there and all the different criteria that you’ve just been talking about. What tools are available to them so that it’s easier for them to determine which issuers are better off or worse off financially?

COOPER: There are many different tools and resources available, but what I would say is that the most important tool is a credit rating. And a credit rating seeks to distill all of this information into one simple metric, and it’s the rating agency’s opinion about the financial health of that issuer. And the largest rating agencies are Moody’s Investor Services and Standard & Poor’s, or Moody’s or Standard & Poor’s.

And now in terms of what to do, we actually suggest that investors focus most of their municipal bond portfolio on higher-rated issuers. Those are ratings that are either double-A or triple-A. And, generally, higher-rated issuers, they have a greater financial flexibility and greater resources available to them to manage through some of these issues ahead. Now, investors with a little bit higher of a risk tolerance, they could consider adding some lower-rated issuers. Those that are single-A, while still being investment-grade rated.

MARK: Cooper, in the 2008 financial crisis, rating agencies came under a lot of fire for being overly optimistic when it came to some of the bonds they were issuing. Do you think investors still should be using ratings at this point? Are they still accurate? Are they still useful?

COOPER: We think that they are still useful, and it’s an important point to consider is what a rating is and what a rating isn’t. A rating is an opinion. It’s not a guarantee. Also, many of the issues in 2008, they were mainly tied to how the rating agencies analyzed mortgage-backed securities, and not municipal bonds. And, historically, the rating on a municipal bond has been a fairly good predictor of that issuer’s ability to make timely interest and principal payments. For example, according to a Moody’s study going back nearly 50 years, the average rating one year before a municipal bond defaulted was B1, and that’s a junk rating, Mark.

So this highlights some important points. First, if you’re concerned about your bond defaulting or missing an interest or principal payment, focus on investment-grade-rated issuers. This is no guarantee, but it generally helps to focus on higher-rated issuers. The second point is pay attention to ratings downgrades and the reasoning for that downgrade. And then a final point I’d like to add is that municipal bond defaults, they tend to be much lower than corporate bond defaults. For example, that same Moody’s study going back 50 years found that out of 10,000 rated municipal bonds, on average, only eight missed a timely interest or principal payment over that five-year period. And this compares to roughly 650 for corporate bond issuers.

MARK: Cooper, final question, then I’ll let you go. You interact with clients all the time. What are the biggest misconceptions that investors have about municipal bonds?

COOPER: One of the biggest misconceptions, and we’ve talked about it here a little bit, is they treat the municipal bond market as the same, when, in fact, there is no one single municipal bond issuer, and there’s no one single municipal bond market. There are some bonds that are backed by a specific tax or a specific debt pledge. There are others that are backed by revenues. So don’t just treat the entire bond market with the same broad brush.

MARK: Cooper, great insights, as always. I appreciate your time today. Thanks.

COOPER: Thanks, Mark.

MARK: The familiarity heuristic is fiendish. In fact, I don’t even like to call it a bias because we think of biases as just plain bad things. Familiarity isn’t quite like that. The fact is, we should have a certain level of familiarity with the securities we put in our portfolio. It’s entirely possible that investors who prefer companies that are nearby may have some sort of an information advantage that warrants a large position in those firms.

As we heard from Cooper, there are even built-in tax advantages for local investors to hold certain types of bonds.

But like all heuristics based on a solid principle, we often push them too far. We take them to an extreme, and we end up undoing much of the good that we were trying to achieve.

So what to do about it? Well, seeking out some sort of advice could help you avoid the familiarity bias and question some of your own assumptions about your portfolio. Whether you are a self-directed investor or prefer working with a financial advisor, Schwab has a range of investment advice options you can explore at schwab.com/advice.

Thanks for listening. To hear more from me, please follow me on Twitter @MarkRiepe. M-A-R-K-R-I-E-P-E. You can also follow Jeff Kleintop, who posts fantastic 90-second videos of what he’s watching in the markets every week. He’s @JeffreyKleintop. J-E-F-F-R-E-Y-K-L-E-I-N-T-O-P.

To read more from Jeff and Cooper Howard, check out the Insights tab on Schwab.com.

We’d also appreciate it if you could also leave us a rating or review on Apple Podcasts. It helps other listeners discover the show.

For important disclosures, see the show notes and Schwab.com/FinancialDecoder.

 

[1]Kayla N. Cytryn, “Lay Reasoning and Decision-Making Related to Health and Illness,” Dissertation Abstracts International: The Sciences and Engineering, 2001.

[2] Gur Huberman, “Familiarity Breeds Investment,” Review of Financial Studies, Autumn 2001.

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