Status Anxiety Or: How Our Neighbors Make Us Worse Investors

The French philosopher Jean-Paul Sartre’s wonderful play No Exit, or Huis Clos in the original French, culminates in the famous exclamation “L’enfer, c’est les autres” — “Hell is other people.” The expression doesn’t mean that other people make our lives hell, but rather that we observe ourselves through their eyes, turning ourselves into objects of comparison and forever using their yardstick as the true measure of our worth. And it doesn’t make us feel good.

Sartre made these insights in 1944, and economists have since found that, at least when it comes to our investment decisions, he was spot on. In our economic choices and self-assessments of our wealth, we compare ourselves with those around us. The most important reference group? Our neighbors. About one-third of households evaluate how well they’re doing by using their neighbors as the benchmark, with work colleagues and family members being the next most common metrics.

Such habits may help explain why most investors have home and local biases, preferring domestic stocks and those in companies that are headquartered close by. If our neighbor, Mr. Jones, works for Coca-Cola, or if we live in Atlanta, we are more likely to own Coca-Cola stock just to keep up with the Joneses. The “Keeping Up with the Joneses” phenomenon may even explain why equities have much higher returns than bonds. It also correlates with a greater tendency to borrow to boost our returns.

In fact, how much inequality exists in a community may have a determinative influence on how much leverage people apply and how successful they are in their investments. During the housing bubble of the early 2000s, evidence suggests, those who moved to neighborhoods with higher income inequality were more inclined to stretch their budgets to purchase a bigger and better home. While the top income earners in a community could afford to, their lower-income neighbors had to take on more and more leverage. This, of course, made them more vulnerable in a downturn. So when the recession hit and the housing bubble burst, they were more likely to lose their homes and drown in debt. As a consequence, inequality spiked further.

And the problem snowballs from there. The more inequality we notice — say, by comparing the size of our homes or the quality of our automobiles with those of our neighbors’ — the greater the likelihood we will take on leverage to boost our returns. When many of us do this, asset price bubbles inflate. In experimental stock markets, these bubbles are easily triggered. But when individual performance and returns are posted publicly, they expand further and faster.

So ranking the best-performing mutual funds, pension funds, and endowments encourages a race within these investor communities. And that competition compels some to take on more risk when their performance lags. And as a consequence, they — and their clients — will suffer more in bear markets.

Why are institutional investors so enamored with private investments these days? Because such assets boost their returns and help them keep pace with the endowment funds at Yale and Harvard or their countries’ largest pension fund. Illiquid assets may pay an illiquidity premium, but their returns may be fueled by debt. So when institutional investors increase their allocation to illiquid investments, they also indirectly increase their leverage. And that may one day come back to haunt them.

Individual investors, too, are jumping on the private equity bandwagon. And as international stocks have underperformed their US counterparts, US investors are questioning the value of international diversification. Why? Because their annoying neighbors never diversified and did much better. And in cities like New York, Paris, and London, banks are easing their lending standards again. So homes can be bought with less equity and more debt — and so prices will continue to spike in these already pricey locales.

Comparing ourselves with our neighbors or our peers creates a vicious cycle. A little bit of inequality is amplified as the less fortunate are tempted to take on more risk than they can afford in order to keep up with the Joneses. This, in turn, magnifies their losses in downturns and creates more inequality, which further incentivizes those who fear falling behind to take on even more risk. And on and on it goes.

So we’d do ourselves a favor by ignoring the Joneses. It’s not easily done, but there are strategies that can help. And the rewards are obvious: We’d have more-diversified and less-leveraged portfolios, which would increase our long-term wealth. We’d also be happier and in better health.

And best of all, we’d give ourselves the greatest chance of beating those Joneses and becoming the wealthiest people in our neighborhood.

For more from Joachim Klement, CFA, don’t miss Risk Profiling and Tolerance: Insights for the Private Wealth Manager, from the CFA Institute Research Foundation, and sign up for his regular commentary at Klement on Investing.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images/ DERBAL Walid Lotfi