Sticking with what you know could be perilous to your investment portfolio.
Familiarity can be one of the most powerful benchmarks clients employ when they make their investment choices. Behavioral economist and University of Alaska-Anchorage professor John Nofsinger, writing in Psychology Today, calls this tendency “familiarity bias.” Nofsinger suggests it can result in an investor assuming too much risk, and thus may lead to poor investment decisions.
Research by the Library of Congress says familiarity bias “refers to the tendency of an investor to favor investments from the investor’s own country, region, state or company.” Why? Because it is natural for people to pick what is most familiar and avoid what they see as alien or strange when faced with a choice between two risky uncertainties. To some extent, that explains why some investors shy away from foreign markets or avoid stocks in favor of what they see as the safety of bonds. It may also help explain why some people invest too heavily in the stock of the company where they are employed.
Familiarity bias is one of 6 behavioral finance principles that govern client attitudes toward investments, according to a CadaretGrant whitepaper produced in partnership with InvestmentNews. You can find a link to the whitepaper on the InvestmentNews website, in the whitepapers section. (Please note you will be leaving Scottrade® property, entering a third-party website and will be subject to their terms and conditions. You may be required to provide personal information in order to access the material.)
The whitepaper suggests ways financial advisors might help clients avoid familiarity bias, and help them achieve the goal of a balanced and diversified portfolio. For instance, advisors might introduce the concept of dividend-paying stocks to clients who avoid equities in favor of bonds. Clients who avoid foreign markets might be open to the idea of investing in multinational stocks.
While your clients may recognize that proper diversification can help decrease risk, they still may be hesitant to act because of familiarity bias. Identifying and confronting this behavior could be a key as you help them achieve properly diversified portfolios.
Explore the Scottrade® Strategic Resource Center to connect with organizations that specialize in portfolio management as well as technology, compliance, research, education and marketing. Many of these resources offer discounts to advisors who custody assets with Scottrade. (Scottrade provides this resource for informational purposes and does not specifically endorse any of the businesses within the directory. Scottrade also does not pass judgement as to whether those services are appropriate for specific business needs. Be advised this is not a full and comprehensive list of businesses that offer these types of products or services and that advisors are responsible for doing adequate research before making any purchases.)