Studies suggest that such familiarity might even make the investment feel less risky even if, in reality, it’s not.
Familiarity may contribute to other investing problems, such as a lack of diversification, and can apply in many other contexts as well – from management decisions to which sports teams to back.
I know you, don’t I?
Back in 1991, Chip Heath (who went on to co-author idea theory bestseller Made to Stick and Amos Tversky (the late, long-time collaborator of Nobel Prize recipient Daniel Kahneman) published an influential paper in the Journal of Risk and Uncertainty about what they called “the competence hypothesis”. The Stanford University academics examined whether feeling like an expert in a field – being very familiar with a topic – affects decision making. They wrote that the “Ellsberg paradox” suggested people avoid betting on ambiguous prospects but through a series of experiments they found that when people feel expert in a domain, the reverse may be true.
Don’t confuse the familiar with the safe
The pair went on to say that this tendency might explain why managers sometimes take risks without actually seeing them as risky.
Furthermore it may explain why some investors might under-diversify. If people are familiar with a certain sector because they work in it day-to-day, there can be a tendency to feel they know it well and allocate a large share of investments to it. In fact, 25% of respondents to this poll recognise they are more likely to invest in the sector they work in. The danger is that if the sector goes through a slump, they are doubly exposed – with employment at risk as well as investments. Think about some of the people caught up in the dotcom boom (and bust) in the late 1990s, where there were heavy job losses as well as heavy investment losses.
Familiar with home economy
A further twist on how familiarity bias might impact on investing choices relates to where we live. Like “home bias” in backing sports teams to win, some investors have a tendency to buy shares from companies in their home country rather than spreading risk across a range of geographies. Like the potential increased risk over-investing in a certain sector, the same can hold true with over-investing in a certain location.
To avoid falling into the familiarity bias thinking trap, a better strategy might be to look at the expected risk and return and other relevant factors for each investment rather than simply picking what is familiar.
Seek out a more objective measure by comparing against generally accepted standards, for example, compare an investment against commonly used index fund to see how your pick varies from the index.
Keep a close eye on fees and if the fees associated with a loan or interest on savings from an “well known” institution vary noticeably from those available elsewhere, question whether your familiarity with that provider is harming your finances.