Help Investors Avoid Familiarity Bias

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.

Clients also might warm to stocks of companies based overseas when they learn about the number of American brands now owned by foreign-based corporations, such as Budweiser, Dial soap, Firestone tires, Toll House cookies, Ben & Jerry’s and Holiday Inns.  

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.

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CadaretGrant and InvestmentNews are not affiliated with Scottrade or any of its affiliates.  The information is being provided for informational purposes only as it may be of interest or value to the client. Third-party websites, research, and tools are from sources deemed reliable. Scottrade does not endorse or guarantee accuracy or completeness of the information and makes no assurances with respect to results to be obtained from their use. 

Diversification may help spread risk, but it does not assure a profit, or protect against loss, in a down market.