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Investing: What You Know Might Hurt You

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The author, Quinn Abrams, an intern at AIER, is a student at Bard College at Simon’s Rock.

Familiarity bias is the tendency for people to prefer a product that they know over one they don’t, even when the alternative may be better. Researchers have found that this bias can cause people to underestimate risk with the things they know well. Most of the time, this is a useful cognitive shortcut.But sometimes our familiarity causes us to gloss over important factors.

As a simple shortcut, gut decision making can help in everyday life. For example, when we find a brand of spaghetti we love, we can stop thinking actively about whether to buy it, because we trust that it will continue to be delicious. This saves us mental energy and ensures us an easier shopping trip.

With other goods, however, we may have to be more careful about making decisions from our gut. When we buy a painkiller for a headache, we have a choice between the name brand product (like Advil) and the store brand product with the same active ingredient (ibuprofen). Many people choose the name brand because they are familiar with the brand and feel that it will perhaps be more effective or cause fewer side effects. In fact, the FDA requires store-brand medicine to meet the same strict standards as the name-brand medicine, so the two products are chemically identical. The only difference between store-brand and name-brand medicines is the packaging and price.

By relying on familiarity as a proxy for a more thorough understanding of these generic medicines, consumers often overspend on name brand medicines. Trusting our intuition instead of relying on objective data can also lead us astray when it comes to investing.

Influence on investment decisions  

Just as familiarity bias costs consumers when buying medicine, it can also cost investors. Familiarity bias shows up in three big ways when it comes to investing:

  1. People buy individual stocks of companies they know without proper regard for the risks of the underlying companies.

A 2001 study from Columbia University found that customers of a regional operating company of Bell System, the former telecommunications giant, were much more likely to invest in the local regional operating company than any other. Though their local company was statistically unlikely to turn a greater profit than others, customers still preferred it, because it was familiar, and thus seemed less risky.

  1. People will invest heavily in the companies for which  they work .

Employees tend to overpurchase the stock of their employer, even when there are no external incentives, like matching plans. They feel that they can trust their employer, so therefore they believe purchasing company stock makes economic sense.

  1. People prefer to disproportionately invest in domestic (U.S.) assets over foreign assets. This form of familiarity bias is sometimes called “home bias.”

A study showed that American and German business students consistently rated stocks from their own country as less risky than those from the foreign country, though in the marketplace the selected stocks performed similarly. Their knowledge of their home country led these students to view domestic stocks more favorably than foreign ones, even though no practical evidence supported that preference.

These three actions can lead to a lack of diversification, which may lead to greater risk than an investor is really comfortable with. In the case of buying company stock, for instance, an investor becomes susceptible to unnecessary risk. What if the company gets hit with a huge lawsuit, causing the stock price to tumble? The employee could suffer in two ways: The job itself may be at risk and the portfolio value would suffer.

This example shows an extreme example of the importance of diversification. It can be hard to ignore your gut when familiarity bias is nudging us to choose from what we know.

What can we do to overcome familiarity bias?

Though in a literal sense familiarity bias is ingrained in our brains, avoiding it can be easy and intuitive.

In order to avoid the risks associated with owning the stock of a single company or industry, many investors have turned to index funds and ETF’s that own a whole universe of stocks. These low-cost solutions mitigate the risk associated with any single company by owning a small share of many companies. When the fortunes of one company or industry are down, we hope that the fortunes of another are up. This diversification should reduce portfolio volatility (price swings).

Take a simple example using only two stocks: Apple Computer (AAPL) and Ford Motor Company (F). Since January 2010, the annual volatility of these stocks has been 26.7 and 29.4 percent. However, an investment split between these two companies has had volatility of 24.1 percent. This is because when one stock is going up, the other might be going down (or vice versa), which reduces the combined volatility. This reduction in volatility is the purpose of diversifying across individual companies. As you add more and more individual company investments, your volatility continues to decline (to a point).

In order to avoid the risks associated with investing entirely within the U.S., many investors have turned to foreign markets to diversify their holdings. Although foreign investments have done worse than U.S. investments in the last few years, we are agnostic about whether this trend will persist in the future. Owning assets from additional countries reduces the risks of economic events that disproportionately or exclusively impact the U.S. stock market.

As you’re thinking about your next investment decision, consider how your hard-earned knowledge and expertise may be unintentionally guiding your decision making process. And be sure to double check that familiarity and confidence don’t play a role, even subconsciously, in your financial calculations.

References

Baker, H. Kent, and Victor Ricciardi. “How Biases Affect Investor Behaviour.” The European Financial Review (2014): 7-10.

Huberman, Gur. “Familiarity breeds investment.” Review of financial Studies 14.3 (2001): 659-680.

Kilka, Michael, and Martin Weber. “Home bias in international stock return expectations.” The Journal of Psychology and Financial Markets 1.3-4 (2000): 176-192.

Kohli, Erol, and Allison Buller. “Factors influencing consumer purchasing patterns of generic versus brand name over-the-counter drugs.” South Med J106.2 (2013): 155-160.

Morgan, J. P. “Profit Sharing/401 (k) Plan, 1997–98 Report to Participants.”JP Morgan, New York (1997).

Wang, Mei, Carmen Keller, and Michael Siegrist. “The less You know, the more You are afraid of—A survey on risk perceptions of investment products.” Journal of Behavioral Finance 12.1 (2011): 9-19.

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