Tens of thousands of potential stock, bond, and mutual fund investments exist in the United States with at least that many choices overseas, as well. So how do investors choose?
Financial theory suggests we should analyze the expected return and risk of each investment. But no, investors tend to trade in the securities with which they are familiar. There is comfort in having your money invested in a business that is visible to you. This familiarity bias has a strong influence on what you buy.
Choosing investments is an exercise in decision-making under risk and uncertainty. Chip Heath and Amos Tversky show in a series of experiments 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! Gur Huberman argues that "Familiarity is associated with a general sense of comfort with the known and discomfort with-even distaste for and fear of-the alien and distant." For example, when given a list of countries and asked to rank order the performance of the economy or stock market in those countries, people rank their home country's performance better.
This sentiment can also be expressed in the form of affect, a belief that investment alternatives that are more familiar are better than those that are not. In this case, "better" usually means that they have higher expected return and lower risk than unfamiliar ones. (see post on affect)
How does the familiarity bias impact you as an investor? The main problem is that when you buy the familiar, you underestimate the amount of risk in the investment. Because you underestimate the risk, you do not take the purposeful steps of reducing risk, like diversifying. So you end up taking more risk than desired. Implications are:
-Inferior asset allocation
-Too much allocation to one or few stocks
-Preferences for local stocks (home bias)
-Preferences for cultural proximity
-Preferences for professional proximity
These will be illustrated in future posts.
See Heath, Chip, and Amos Tversky, 1991, "Preference and Belief: Ambiguity and Competence in Choice under Uncertainty," Journal of Risk and Uncertainty, 4, 5-28, and Huberman, Gur, 2001, "Familiarity Breeds Investment," Review of Financial Studies, 14, 659-680.