Familiarity bias

What Is Familiarity Bias?

Familiarity bias is a cognitive bias in the field of behavioral finance where individuals show a preference for investments that they are familiar with, often regardless of objective investment principles like diversification or optimal risk-return profiles. This inclination stems from a false sense of security or superior knowledge about well-known assets, companies, or local markets. Instead of conducting thorough due diligence or seeking a broad range of investment opportunities, individuals affected by familiarity bias tend to stick to what they know, potentially limiting their portfolio's growth and increasing its uncompensated risk. Familiarity bias can manifest in various ways, from investing predominantly in domestic stocks to favoring a company where one works, despite the lack of objective reasons for such a concentrated investment strategy.

History and Origin

The concept of familiarity bias emerged within the broader development of behavioral finance, a field that integrates insights from psychology and economics to explain why people often make seemingly irrational financial decision making. Pioneers like Daniel Kahneman and Amos Tversky laid much of the groundwork in the 1970s with their work on heuristics and biases, most notably Prospect Theory. While familiarity bias was not explicitly named in their earliest work, it is a natural extension of the idea that individuals deviate from purely rational economic behavior due to cognitive shortcuts and emotional influences. The inability of traditional financial models to fully explain certain market anomalies prompted researchers to explore these psychological underpinnings. The study of behavioral finance has evolved since the 1980s, identifying various biases, including those related to information processing and perception of risk, which contribute to familiarity bias.⁴

Key Takeaways

• Familiarity bias is a behavioral tendency to prefer known investments over unknown ones.
• It often leads to under-diversified portfolios and concentration risk.
• The bias can stem from perceived superior knowledge, comfort, or nationalistic tendencies.
• It can hinder access to better returns or lower risk from broader global markets.
• Recognizing familiarity bias is the first step toward mitigating its adverse effects on investment outcomes.

Interpreting the Familiarity Bias

Familiarity bias suggests that an investor's comfort with certain assets or markets can lead to suboptimal asset allocation decisions. For example, an investor might believe they have superior insight into a domestic company or industry simply because they live in the same country or consume its products. This perception can be misleading, as professional analysts and large institutions typically possess far more comprehensive information and resources. Interpreting the presence of familiarity bias in a portfolio often involves identifying a significant overweighting of assets from a specific region, sector, or company that isn't justified by a robust portfolio management strategy or objective analysis of future returns and risks. It highlights a deviation from the principle that investment decisions should be based on a thorough evaluation of an asset's fundamentals and its role in a diversified portfolio, rather than on subjective comfort or perceived knowledge.

Hypothetical Example

Consider an investor, Maria, who lives in Spain and has 80% of her investment portfolio allocated to Spanish stocks and bonds. Her reasoning is that she understands the Spanish economy, reads the local news, and feels more comfortable with companies whose names she recognizes. She dismisses opportunities in emerging markets or other developed economies, perceiving them as "too risky" or "too complex" despite their potential for greater returns or lower overall portfolio volatility through geographic diversification.

Maria exhibits familiarity bias because her investment choices are heavily swayed by her knowledge of her home country, rather than by a comprehensive analysis of global investment opportunities. If the Spanish economy experiences a downturn, her portfolio would be significantly more vulnerable than a globally diversified one. Her subjective comfort with local investments overrides objective analysis of global risk tolerance and return prospects.

Practical Applications

Familiarity bias is widely observed across various facets of finance and investing:

• Individual Investors: Many individual investors exhibit a strong preference for domestic stocks, a phenomenon often referred to as home bias. They may feel more comfortable investing in companies headquartered in their own country, believing they understand them better. This often results in portfolios that are inadequately diversified internationally.³
• Corporate Employees: Employees often concentrate a significant portion of their retirement savings in their employer's stock. While this can sometimes be advantageous, it creates a highly concentrated position subject to both market risk and company-specific risk, especially concerning potential job loss concurrent with a decline in company stock.
• Institutional Investors: Even large pension funds and institutional investors can exhibit familiarity bias, often overweighting domestic assets compared to global benchmarks. This can be due to regulatory constraints, governance issues, or a perceived informational advantage in their home markets. The Organisation for Economic Co-operation and Development (OECD) has studied how pension funds diversify internationally, noting persistent tendencies toward domestic investments.²
• Local Investments: Investors might prefer to invest in local real estate or businesses they frequently encounter, overlooking potentially better opportunities elsewhere.
• Financial Advisers: Advisers need to actively identify and address familiarity bias in their clients' portfolios. Educating clients about the benefits of broad diversification and global markets is a key step in mitigating this bias. The U.S. Securities and Exchange Commission (SEC) highlights the importance of understanding behavioral biases in investor decision-making.¹

Limitations and Criticisms

While recognizing familiarity bias is crucial for sound financial decisions, completely eliminating it can be challenging. One limitation is that a degree of familiarity can genuinely provide an informational advantage, particularly for private equity or highly localized ventures. However, for publicly traded securities, this advantage is often overstated given the efficiency of modern financial markets and the rapid dissemination of information.

Critics of behavioral finance concepts sometimes argue that while biases exist, sophisticated investors and market efficiency mechanisms tend to correct for them over time, minimizing their aggregate impact. However, persistent anomalies like home bias suggest that the effects of familiarity bias are durable for many individual and even institutional investors. Efforts to counteract familiarity bias often involve battling other cognitive tendencies, such as overconfidence bias, where investors overestimate their knowledge, or loss aversion, where the perceived safety of familiar assets outweighs the potential gains from venturing into the unknown. Overcoming familiarity bias requires a conscious effort to adopt a disciplined, evidence-based approach to investing rather than relying on comfort or intuition.

Familiarity Bias vs. Home Bias

Familiarity bias is a broader cognitive tendency, while home bias is a specific manifestation of familiarity bias in the context of international investment. Familiarity bias describes the general preference for anything known, whether it's a specific company, industry, or geographic region. For instance, an investor might prefer a stock because they use its products daily, or a bond because it's issued by their state government. Home bias, on the other hand, specifically refers to the observable tendency of investors to allocate a disproportionately large percentage of their equity portfolios to domestic stocks, relative to what would be suggested by a globally diversified, market-capitalization-weighted portfolio. While all instances of home bias are examples of familiarity bias (investors are familiar with their "home" market), not all instances of familiarity bias are necessarily home bias (e.g., preferring a specific local small business over others might be familiarity bias, but not strictly home bias in the international equity sense).

FAQs

What is the main problem with familiarity bias in investing?

The main problem is that it leads to under-diversified portfolios, concentrating risk in a smaller range of assets or markets than is optimal. This can result in lower potential returns for a given level of risk or higher risk for a given level of return, hindering long-term wealth accumulation.

How can investors overcome familiarity bias?

Overcoming familiarity bias involves actively seeking out and researching investments beyond one's immediate sphere of knowledge. This means exploring international markets, different industries, and various asset classes. Utilizing professional financial advice, relying on objective financial analysis, and committing to principles of broad diversification can help mitigate this bias.

Is familiarity bias always a negative thing?

While generally considered detrimental in investing because it restricts opportunity and increases uncompensated risk, a degree of familiarity might provide a genuine informational edge in very specific, niche, or private investment scenarios where public information is scarce. However, for publicly traded securities, the perceived informational advantage from familiarity is often outweighed by the benefits of global market efficiency and broad diversification.