Familiarity bias: How can traders avoid the pitfalls?
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You’ve picked your assets, feel like you’ve diversified effectively, and are on track to begin trading successfully. But something feels all too familiar. Familiarity bias may affect your decision-making while trading, causing you to only stick to assets that feel like home.
What is familiarity bias?
Traders are prone to taking all kinds of psychological shortcuts in their decision-making, often leading to serious losses.
Analysis by the CFA Institute showed these shortcuts in part caused a slow response to a stock market rally during Covid-19 lockdowns, and the similarly delayed reaction to rising inflation. Another major shortcut leads to familiarity bias.
Familiarity bias in trading refers to the tendency to trade in assets that a trader already knows, leaving them more susceptible to trading based on emotions.
This can occur by trading assets that are based in the trader’s home country. This may appear logical – the trader is likely more familiar with their local economic context. But, it also means that the trader may be ignoring better-performing assets because they are headquartered elsewhere.
Familiarity bias towards equities. Investors may skew towards trading in stocks with which they are familiar, like Netflix (NFLX), Facebook owner Meta Platforms (META) and Tesla (TSLA), rather than observing the wider context, following market-moving news and the economy.
According to behavioural finance experts, these biases are caused by an innate psychological fear of the unknown. A Columbia University study by Gur Huberman suggested that this went against standard portfolio-building theories.
Familiarity bias can give way to a host of other behavioural shortcomings that could worsen an investor’s outcomes, like confirmation bias and loss aversion.
Home bias
Perhaps the most pervasive form of familiarity bias occurs on a geographical basis. Investors are most prone to trading assets that are close to home, due to the aforementioned psychological factors driving decisions.
Vanguard research found UK investors were leaving huge gains on the table by backing domestic assets and ignoring areas like the tech sector which boomed through the pandemic.
In the US, familiarity bias is overwhelming. Citing research by JPMorgan, Raymond James pointed out that despite the US accounting for a small share of global gross domestic product (GDP), US investors held nearly 75% of their investments in US assets.
Most studies suggest that home bias pierces through a majority of countries, and the losses from familiarity bias can vary accordingly.
For example, prior to this year’s bear market, a US investor displaying home bias would likely have done better than one in the UK, with the S&P 500 (US500) growing by more than 10% over the last five years, compared to less than 3% growth for the FTSE 100 (UK100) over the same time.
Stock familiarity
Another familiarity bias example that leans on traders, particularly those starting out, may encourage them to plunge their cash into equities that they are familiar with.
Stock familiarity bias is a tendency to choose companies that have performed well in the past, are well-known, or that the trader has some personal connection towards, such as buying products from them.
For example, an investor starting out may decide to add Facebook owner Meta Platforms (META), Tesla (TSLA) and Netflix (NFLX) to their portfolio, observing their considerable market cap and evidence of good performance, forgetting that the stocks may have experienced losses this year.
Or they might decide to back industry stalwarts, for example Ford (F) in the automotive sector. While this can be successful if a legacy company adapts, it also ignores new disruptors coming through the ranks.
These traders tend not to focus on a company's fundamentals or other factors that define their trading strategy, and accordingly leave themselves prone to suboptimal outcomes similar to home bias.
Industrial bias
Industrial bias can be another sub-category of home bias, dependent on the industrial strengths of the country in which the home bias occurs. Analysis by Robin Powell, head of client education at Rockwealth surmised this for some of the major Western economies.
In Australia, on the other hand, materials stocks – those companies engaged in mining, processing and developing raw materials – make up more than 25% of the stock market, well above 10% in the UK and 3% in the US.
For the UK, on the other hand, “the biggest sector is consumer staples – think brands like Unilever, Diageo and Tesco – which make up almost 20% of the MSCI UK index, compared with just 5-6% in the US and Australia.
Sectors that a typical trader is less familiar with, like mining or agriculture, might also be neglected in place of tech and retail, because they are better known and perhaps more tangible to a trader.
How to avoid familiarity bias
Avoiding familiarity bias might depend as much on mindset as strategy. While a trader can soften the blow of familiarity with thought-out diversification, simply being aware of the familiarity bias may be enough to help optimise your decision making when trading.
Diversification
Diversification is one of the key methods for breaking out of familiarity bias, meaning that traders need to spread their positions across a wide range of asset classes, and trading in several assets between those classes. This can allow a trader to put money into familiar assets while offsetting them against others.
Traders can diversify geographically, jumping between developed and emerging markets and their companies, commodities, debt, and currencies.
Trading in different instruments and derivatives such as option and future contracts and contracts for difference (CFDs), which allow traders to open short positions, can also form part of a diversification plan.
A diversified trading range may result in poorer overall returns, but it could smooth out volatility, and give the trader a more considered approach to observing which assets are performing as hoped.
Remember to always conduct your own research before trading, looking into fundamental and technical analysis, latest news and analyst commentary. Note that past performance does not guarantee future returns. And never trade money you cannot afford to lose.
Think again about your trading
It can be useful for a trader to review their biases when they begin to creep in, given that behavioural shortcomings tend to occur subconsciously.
A trader could ask why they are opening or closing a certain position, observing fundamentals and technicals of an asset, and previous market-moving news and how likely this is to impede the asset.
Checking the top risers and top fallers on a regular basis could add to a considered approach, as well as tracking the top performers in an uptrend and the biggest fallers in a downtrend.
FAQs
How do you overcome familiarity bias?
Familiarity bias can be overcome by careful, considered trading based on diversification, observing the news, checking risers and fallers, and staying self-aware. Remember to always conduct your own due diligence before trading.
Who came up with familiarity bias?
Familiarity bias is an offshoot of availability heuristics, founded by Israeli psychologists Daniel Kahneman and Amos Tversky.
What are the behavioural biases?
The best-known behavioural biases include mental accounting, loss aversion, overconfidence bias, anchoring bias and herd behaviour bias.
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