A family resemblance not always welcome, even in an era of uncertainty

For many, summer is an opportunity to get away and recharge. Some take advantage of the long summer holidays to seek a bit of exoticism, sometimes by discovering a country on the other side of the world. Others, on the contrary, prefer to return to places they are particularly fond of. This latter option naturally leads us to the concept of familiarity bias, a common tendency among investors who disproportionately favor what they already know.

Familiarity bias: a pillar of the cognitive bias family

What do Victoire, an employee who limits her investments to her company’s shares, Grégoire, who has a professional background in finance and prefers debt financing for the company he runs, and Louis, an investor who favors companies whose brands of goods and services he uses, have in common? All three display behaviors marked by familiarity bias—a tendency to prefer investing in assets one is already familiar with.
Let’s paint the family portrait of this bias, highlighted in 1991 by a publication from researchers Amos and Tversky, who sought to challenge the ambiguity aversion hypothesis (introduced in our article: “The Grass Isn’t Greener in Our Personal Finances Than in Our Garden”). They conducted a series of experiments in the United States, asking students to bet a sum of money to answer a question, with a correct answer (on sports predictions, upcoming elections, general knowledge, etc.) earning them 15.
Unsurprisingly, the more students felt in their comfort zone (for example, complex questions about their own university rather than another American state’s, or about the distance between two cities including their own rather than two cities in Asia, etc.), the more they preferred to bet based on their knowledge gather than leave it to the randomness of a lottery (507.12 to bet on a familiar subject and only $5.96 for an unfamiliar one. These rigorous experiments, whose results may seem intuitive, marked an important turning point by precisely quantifying, at 20%, this “competence premium” (as termed by the authors). Thus, we are willing to bet more when we feel competent in a field, even if our judgment is more ambiguous than a binary probability.
Of course, familiarity bias has long been used in marketing and its cousin, advertising. In fact, this is one of the virtues of advertising: repeated communication around a brand aims to get the consumer used to and familiar with it, so that they are more likely to purchase one of its products. But beyond the impact on our daily consumption habits, it is important to consider the consequences of this bias in managing our personal finances.

Becoming familiar with its impact on our investment decisions

Understanding—and therefore being familiar with—the financial solution in which one invests is obviously a wise, even essential, prerequisite before making any decision. However, we should favor the notion of familiarity in the sense of understanding—sometimes at the cost of effort—rather than familiarity resulting from consumption habits (for example, investments in companies with strong brands), investment habits (in a single asset class), nationality (the domestic bias of a French person investing only in French stocks), culture, etc.

In times of uncertainty, clinging to assets we are familiar with seems even more natural. But even in turbulent times, the inclination toward familiarity too often fuels a mistaken perception of reality, affecting our decision-making.

First, because we tend to underestimate the risk and overestimate the return potential of an asset class (or an asset itself, such as a stock) we consider ourselves knowledgeable about. Here we find the “competence premium”, which threatens a rational risk/return approach by encouraging excessive risk-taking linked to supposed expertise.

Second, because this irrationality can also lead to suboptimal allocation through excessive concentration on a familiar asset, or on assets that are similar and therefore may be too correlated. Limiting investments to overly similar assets prevents prudent diversification, which is just as important as a good understanding of what one is investing in.

Ultimately, it is worth making some effort (or being well advised) to go beyond what we know and thus wisely expand our investment family!

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In finance, what resonates most with us will not necessarily generate the performance we’ll want to talk about.
 

¹Preference and Belief: Ambiguity and Competence in Choice under Uncertainty, C. Heath, A. Tversky, 1991
https://courses.washington.edu/pbafhall/514/514%20Readings/ambiguity%20and%20competence.pdf
²Frieder and Subrahmanyam (2005) present evidence that individual investors prefer stocks with high brand recognition.