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  • Writer's pictureRyan M. Vogel, CFP®

Familiarity Bias: Danger of Investing in Only What You Know


Face being covered by eye mask which reads "bias"

Key Takeaways

  • The stock market does not reward investors with higher returns for loyalty or familiarity.

  • Invest in what aligns with your financial goals and risk tolerance – not in what’s familiar to you.

  • It’s not being “disloyal” to sell inherited or employer stock that no longer meets your needs.

  • A skilled advisor can help prevent impulsive or emotional decisions from derailing your financial plan.

At Novi, we see many people succumb to different behavioral biases every day, often without realizing it. Helping people manage their investment behavior is one of the core benefits we provide. While we frequently talk about investment analysis and selection, these decisions mainly impact investment returns to the right of the decimal point. What’s impactful to investment returns is managing investment behavior. That’s what impacts investment returns to the left of the decimal point.

silhouetted business people in police line up

When we meet with prospective clients, they frequently own stocks in the “usual suspects,” AT&T, Verizon, Microsoft, Procter & Gamble, Johnson & Johnson, and the list goes on. They often inherited those shares from parents, or simply hold those shares forever because they are familiar with the company’s products. Many people also own large concentrations of their employer stock or large holdings of healthcare and pharmaceutical companies for the same reason -- because they are familiar with them or work in the industry. Behavioral finance experts call this “familiarity bias.” That’s when investors invest in what they know instead of what makes the most sense for them. As a result, investors are not sufficiently diversified across multiple sectors and types of investments, which increases their risk and can drag down their returns.

People tend to invest in the familiar because it seems less risky. However, the stock market does not reward investors with higher returns for loyalty or familiarity. There is a long list of stocks that were once among the largest in the world-dominating industries that are either struggling or no longer in business. Companies like Woolworths and Kodak come to mind.

There are emotional components to familiarity bias, too. Inherited stocks carry sentimental value and selling company stock may come across as “disloyal.” However, it just takes one bad piece of news to dent a company’s performance and thus, impact your investment returns and financial plan.

Familiarity bias also explains why many people are reluctant to invest in foreign stocks or small U.S. companies they don’t know well. They might pass on an opportunity to invest in a promising small company and instead put their money into an underperforming stock whose products they know. This type of behavior erodes returns and can subject investors to more risk than they realize.

Calendar with hourglass on top

A skilled advisor can also help you stay disciplined and construct a portfolio that provides an appropriate amount of return for the level of risk being taken. Stock investing and retirement planning are long-term games. We will sometimes experience times like 2000 to 2010 when U.S. stocks returned essentially nothing for an entire decade. If you convinced yourself then that the “Lost Decade” would continue indefinitely and that stocks should be avoided going forward, you would have missed out on the robust recovery for U.S. stocks in the following decade. When you see those kinds of extremes in long-term returns, it represents opportunity. For example, there are now many opportunities in non-U.S. stocks and smaller company U.S. stocks or value stocks. These are areas that have recently not done as well as some familiar U.S. large stocks, but that trend won’t persist forever. Investors who are patient and who understand how to structure investment portfolios properly will ultimately benefit from higher returns while taking an appropriate amount of risk. While it is tempting to pile into familiar stocks, especially when those stocks have performed well recently, you must maintain your discipline and NOT follow the herd. We've seen this movie many times before and following the herd usually doesn’t end well. I’ll talk more about “following the herd” bias in an upcoming post.

Conclusion

Investors tend to be their own worst enemy. DALBAR is a research firm that conducts an annual quantitative study of investment behavior. Their results show that the average retail investor consistently underperforms the returns of the funds in which they invest. How can that be? Because they succumb to bad investment behavior and allow their emotions to dictate their actions. Examples of this include trading during stressful times in the market or over-concentrating their portfolio in certain stocks or industries. That’s why helping clients manage their impulses and behaviors is one of the most valuable things we do for them.

In my next several posts, I will discuss other common behavioral biases that can derail your investment plan. If you or someone close to you has questions about their investment strategy, asset allocation, or retirement readiness, please don’t hesitate to reach out. We are happy to help.

 

RYAN M. VOGEL, CFP® is the CHIEF PLANNING OFFICER, PARTNER at Novi Wealth



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