Although theory may deem markets to be efficient, investor biases can explain a lot about why assets are often mispriced.
The statement quite sums up the financial markets and financial decisions. It is often assumed that markets are supposed to be efficient and the investment decisions are supposed to be rational all the time, however, it is not the case. The human mind and the process of investment is more often than not affected by the behavioural biases. These inherent biases plague individual investors.
The behavioural biases lead the investors into making irrational and illogical decisions. The fact that the investors are mostly unaware of the biases makes it all the more difficult for them to overcome. A significant behavioural bias that impacts the investors is the Familiarity Bias.
In day-to-day life, we find many people who will only buy a specific brand of clothes, go to the same store each time and take the same route to reach the store. These are the examples of familiarity bias in routine life.
Familiarity bias is the preference of the individuals to remain confined to what is familiar to them. They wish to remain within their comfort zone and do not want to take the path never taken. Humans have a tendency to believe more in the choice that they recognise and are aware of. Unfamiliarity makes them uncomfortable and unsure.
The familiarity bias is very commonly observed in investing, too. Investors have an inclination towards buying the stock that they are familiar with. This may mean buying the stock of their own country, own company or of companies that they are aware of and whose products they commonly use.
For instance, when presented with an option to choose between the stock of Apple and Synaptics, the investors are more likely to choose Apple. It is because they are familiar with the company and use its products more often. The familiarity bias prevents the investors from analysing the actual potential of the lesser known companies and stocks, that may turn out to be more profitable than the familiar options.
Causes of the Familiarity Bias
The primary cause for the familiarity bias has been explained by Benjamin Graham in ‘The Intelligent Investor’. He says that the investor’s chief problem and his worst enemy is likely to be himself. The investors have a tendency to get in their own way while making investment decisions. Seeking help with investments is considered a sign of weakness by them.
The familiarity bias can also stem from the loss aversion bias. In order to avoid losses, the investors are afraid of diversification and tend to remain confined to their comfort zone. It can also be caused by the availability bias as more information is available for the familiar stocks and companies; or by the herd behaviour which prevents the investors from taking decisions that the others are not taking.
Effects of the Familiarity Bias
The implications of familiar bias are multiple and obvious. Due to the familiarity bias, the investors fail to diversify their portfolio. The asset allocation remains restricted to the familiar stocks and the portfolio becomes inferior.
The investors also end up losing several opportunities due to their resistance to try out something new. An unknown or lesser known stock may give a lot more profits than a familiar one. But, the investors choose to oversee the opportunity, in order to avoid the risks.
This is to be remembered that familiar does not mean safe. In the process of remaining confined to the familiar, the investors may not do their research and analysis and may end up investing in a loss-bearing company.
How to Overcome the Familiarity Bias?
The most important step to overcome the familiarity bias is to accept that familiar is not necessarily safe. Also, the investors must not consider seeking help as a sign of weakness.
The investors should create checks and balances in their investing account time-to-time. They must evaluate and reevaluate the options for optimum portfolio management and asset allocation. This will make them aware of the other opportunities, and will also help them to weed out the familiar stocks and companies that are not performing as well as they were.
To overcome the familiarity bias, the investors must attempt to reduce investing in home economy, home companies and companies they work for. Conscious attempts in this direction will help them diversify.
In the end, each stock and each opportunity must be analysed individually, without any form of bias. The risks and rewards should be understood in detail and the investment decisions should only be based on the objectivity of the outcome. This will lead to more rational and logical decisions, compared to the irrational decisions caused by the behavioural biases.