The subconscious biases putting your investments at risk - Part 4
We’ve made it!
Part 4 marks the end of our series, and as the first content series we’ve put together, we’re excited we’ve all made it here in one piece.
Our final article covers Familiarity, but we’ve also looked at Loss Aversion, Hindsight, Herding . If you missed one of them then why not go back and have a look at how else we might be poorly influencing our investment decisions.
Let’s get familiar with Familiarity then
Stick with what you know, right?
Familiarity bias is a our human instinct to keep going with what we’re accustomed to. Whether you consider it your bubble or comfort zone, or simply being a creature of habit, familiarity is a natural reaction for any human to stick to what they know.
A few of the odd ones that spring to mind:
- Standing in the exact same place for the train everyday, regardless of how useful that spot is when you get to the other end
- Taking the same route to get somewhere for years and years, regardless of how efficient it is
- Looking at the menu of your favourite restaurant for 20 minutes despite knowing exactly what you’re going to have - the same thing you always do!
Sometimes these actions are completely irrational, sometimes they’re based on the best intentions but from outdated knowledge. But they’re mostly due to knowing our comfort level and not currently seeing a need to change.
The danger of all this is that we’re creating a situation that is preventing us from acting objectively, even if there is a tangible benefit from doing something else.
So what does all of this have to do with investing?
In 2014, Professors Kent Baker and Victor Ricciardi co-wrote Investor Behavior: The Psychology of Financial Planning and Investing, a book providing investment professionals with in-depth insights on how to understand an individual's behavior.
Naturally, they covered a wide range of biases and actions to watch out for, one of them being an assessment of Familiarity.
Courtesy of the European Financial Review, they describe it as:
‘This bias occurs when investors have a preference for familiar investments despite the seemingly obvious gains from diversification. Investors display a preference for local assets with which they are more familiar (local bias) as well as portfolios tilted toward domestic securities (home bias).’
Essentially, we have an issue with quite literally not expanding our horizons when it comes to investing.
So it’s just about geography?
Actually, there are additional issues that familiarity can cause.
Chip Heath and Amos Tversky (our friend throughout this series) carried out a study on this back in 1991, which was published in their paper titled Preference and Belief: Ambiguity and Competence in Choice under Uncertainty which featured as part of the Journal of Risk and Uncertainty. Catchy title.
They ran a series of experiments that proved when people are faced with a choice between two gambles, they will pick the one that is more familiar to them. They will sometimes even pick the more familiar gamble even if the odds of winning are lower.
In applying this to investing, our familiarity bias means we have a tendency to stick to the sectors and companies we know.
Understandable given we could feel we have heightened knowledge for a particular sector - often the case when we’re an avid user within a sector/market, or work within it.
As a user or employee (or from word of mouth from one of those two), we can become overconfident in certain stocks because we have a positive outlook clouding our view of the whole picture of the company/sector.
What’s the issue with this?
Quite simply, this could cause a catastrophic failure of your portfolio if you’re over-allocated into one sector.
Think back to the dotcom bubble.
Some of those that were hit the hardest were workers in the sector, where the company they worked for virtually vanished overnight, meaning they not only lost their job but could’ve also been left holding worthless stock in the now deceased company.
They possibly even had a third layer of downfall by being over-allocated across the whole sector at that time.
To sum it all up
The implication of all of this is that investors can very easily end up creating ‘suboptimal’ portfolios, whether from lack of diversification of geography, sector or asset type.
Creating well rounded and diversified portfolios is key, and this can only be done by removing bias such as this from your decision making.
What else should we watch out for?
There are countless other issues that are clear in human decision making, and these can become an even greater issue for outcomes when they impact our hard earned money.
But don’t panic. There’s one thing that makes us (at Exo) feel better - data doesn’t get emotional.
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