How to curb familiarity bias and boost your portfolio
Familiarity bias can limit your trading opportunities, weaken your portfolio, and increase the risk of losing money – so what is the solution? Go forth and diversify
Sticking with the familiar seems like the sensible option, right? It’s why so many of us return to the same holiday destination each year. Familiarity takes away the risk of making a bad decision – we know what we like, so why not stick to it?
The problem with this safe approach is that we may miss out on new places that are better, cheaper and frankly more fun. In addition, good places go bad – just because it was a safe bet last year, doesn’t mean you’ll get the same experience.
This is known as familiarity bias, which is common in trading – particularly if you are a novice trader, or someone that trades in your spare time. Just like that one holiday a year, you don‘t want to get it wrong, so you invest in shares that are familiar to you. They could be from your home country, in sectors/industries familiar to you, or with well-known branded shares.
This field of research is called behavioural finance, which is the study of biases that plague individual investors and affect their trading decisions – and therefore the markets.
According to Gur Huberman, professor of behavioural finance at Columbia Business School, familiarity bias in behavioural finance is “associated with a general sense of comfort with the known and discomfort with – even distaste for and fear of – the alien and distant."
Going with the familiar also saves a lot of time, as stocks and shares we know are easier to research and monitor. With thousands of shares to choose from, deciding which to back can be overwhelming, so sticking with what we know is undeniably tempting.
Plus there is a sense of loyalty at play – we want to back the home team. As a result, we can unconsciously build prejudice against unknown shares, which could mean missing out on attractive trading opportunities for higher profits and lower risks.
“It’s great to be able to see that your retail investment has a high-street shop near you, or the oil company whose shares you own is the branded petrol station around the corner,” says Ekatarina Serikova, curreny.com’s behaviour analyst.
“You can see it and trust it, and it’s familiar – even if the shares are underperforming compared with similar firms in other countries. But in doing so, you miss out on the opportunities presented by lesser-known more volatile stocks.”
The familiarity bias also stems from loss aversion bias, where investors remain in their comfort zone to avoid loss, and herd instinct which see traders making investing decisions based upon the choices of others.
Familiarity bias and investment
The main problem with familiarity bias in trading is that it limits your opportunities and weakens your portfolio, which significantly increases the risk of losing money. Also, when you only invest in the familiar, you often fail to fully evaluate the risk involved, because it feels safer.
A series of experiments by psychologists Chip Heath and Amos Tversky found that when people are faced with a choice between two gambles, they will pick the one that is more familiar to them. In fact, they will sometimes pick the more familiar gamble, even if the odds of winning are lower. By underestimating the risk, you then fail to take necessary steps to reduce risk, such as diversifying (more on this below).
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The faces of familiarity bias
Home bias: this is the most common type of familiarity bias, and sees investors focusing on domestic equities, when they could be making profits overseas. Foreign stocks often outperform those in your home country, so failing to diversify internationally can make trading limited and risky.
Employer bias: even if your employer is a successful, publicly traded company, owning company stock still comes with its risks – especially if it means a large percentage of someone’s net worth is tied up in an individual stock. One example of this is with Enron, which collapsed in 2001 after it was revealed that America's seventh largest company was involved in corporate corruption. As a result, one employee reportedly saw his retirement account drop from $470,000 to $40,000. This highlights the value of diversification.
Bias to companies you like also comes with risk: just because you respect or like a company, or use its products doesn't make it a good investment. You may love using Uber cabs, but right now investing in this company would be risky. Investing should involve analysis and research and not just be based on personal preferences.
How to avoid familiarity bias
The most important step to avoiding familiarity bias is to accept that familiar doesn’t equal safe. This doesn’t mean you should never invest in securities close to your heart, but it does mean you should analyse each stock and each opportunity individually, without any form of bias. This will lead to more rational and logical decisions.
Diversification is key. So aim to reduce your investments in domestic stocks, familiar companies and companies you work for – and look further afield. Traders who diversify are less likely to lose a significant portion of their investments, just because a particular company or industry doesn’t perform well.
By spreading investments across a broad selection of assets, losses in one part of the portfolio will hopefully be offset by gains elsewhere. You should also regularly evaluate your portfolio, to keep informed of new opportunities, and weed out any familiar stocks and companies that are not performing well.
“The markets aren’t your new best friend, they are not emotionally tied to you,” says Serikova. “To overcome this bias, you need to expand your portfolio and gain wider diversification to reduce your level of risk.
“By trading different asset classes on different markets, you are more likely to avoid familiarity bias and emotional attachments to market instruments.”