The tendency to make comparisons can drive people and investor communities to overstretch themselves
Classical economic theory holds that competition is a healthy component of any market: as participants struggle to get customers and dollars, they compare themselves against their rivals. If they lag in some area, they work to close the gap and eventually get ahead. But when it comes to investing and spending, the tendency to compare might not be so helpful.
That’s the main point driven home by Joachim Klement, CFA and trustee of the CFA Institute Research Foundation, in a recent blog post. “About one-third of households evaluate how well they’re doing by using their neighbours as the benchmark, with work colleagues and family members being the next most common metrics,” he wrote.
He noted that the “Keeping Up with the Joneses” phenomenon could help explain the higher returns in equities compared to bonds, as well as a heightened tendency among investors to borrow to boost their returns.
The problem is compounded when there’s a state of inequality. “During the housing bubble of the early 2000s, evidence suggests, those who moved to neighbourhoods with higher income inequality were more inclined to stretch their budgets to purchase a bigger and better home,” Klement said. As lower-income neighbours took on leverage to chase after the top earners next door, they ended up more exposed during the recession, consequently facing greater prospects of losing their homes and drowning in debt. The aftermath: even greater inequality.
In experimental stock markets, he said, asset price bubbles are easily triggered and inflated as a function of the disparity in size or quality people notice between their own possessions and their neighbours’. Bubbles grow further and faster, he added, when individual investment performance and returns are posted publicly.
“[R]anking the best-performing mutual funds, pension funds, and endowments encourages a race within these investor communities,” he said. With that competition, some are compelled to take on more risk as their performance lags. Consequently, they and their clients suffer more in bear markets.
Noting the current thirst institutional investors have for private investments — “such assets boost their returns and help them keep pace [with prestigious endowment or pension funds]” — he cautioned that returns from such investments may be fuelled by debt. As for individual investors, he warned of a rush to join the private-equity bandwagon, as well as a tendency to question the value of international diversification “[b]ecause their annoying neighbors never diversified and did much better.”
He concluded by asserting that the simple answer, though it might not be easily practiced, is to ignore the Joneses. “[T]he rewards are obvious: We’d have more-diversified and less-leveraged portfolios, which would increase our long-term wealth.”