What is familiarity bias?
Familiarity bias can be explained as a cognitive bias that causes people to favour information or items that are familiar to them.
In trading, this may mean traders are more likely to make trading decisions based on their own experiences rather than objectively evaluating the situation. For example, trading CFDs from their home country, in sectors familiar to them or globally renowned branded shares.
Highlights
Familiarity bias may lead people to make decisions or form opinions based on what they already know, even if the information is not necessarily true or accurate.
A familiarity bias example would be a trader only trading stock CFDs of companies they interact with as a consumer, leading to them not considering researching other markets.
Acknowledging the existence of familiarity bias and doing thorough research, among other methods, could help limit its effect.
The impact of familiarity bias on investment decision-making
Traders sometimes like to feel familiar with and loyal to their trade, favouring domestically quoted shares they know from their day-to-day life rather than venturing into international investments that would be new to them but may be of similar or better performance.
It’s great to see that your retail investment has a high-street shop near you, or the oil company whose shares you own is the branded petrol station around the corner. You can see it, and it’s familiar, which can evoke trust – even if the shares are underperforming compared with similar firms in other countries.
Familiarity bias in finance prejudices the trader against the unknown, keeping their focus narrow. The main problem is that an asset does not necessarily suit their goals just because it is familiar. Keeping loyalty to one or several stocks could make their portfolio undiversified.
Financial theory says that before making any trades, you should carefully weigh up the potential risks and returns. However, it’s tempting to remain in a delusive state, putting your money into a company you ‘know’, or at least think you do.
According to behavioural finance expert Gur Huberman:
As a result of familiarity bias, traders may expect higher returns and underestimate the risks of an investment. Misjudging the risks, they don’t take all the necessary risk management steps, disregarding one of the most effective tools – diversification.
Examples of familiarity bias in trading
Wishing to stay inside a familiar pool of assets, traders are not always ready to walk the road less travelled. Inclination towards familiar stocks may be divided into several examples:
Bias to your home country
The most common definition of familiarity bias – home bias – reflects portfolios significantly shifted towards domestic equities, without considering international diversification within the strategy. Often, foreign assets could potentially outperform the assets of your home country. Therefore, in this situation, choosing local stocks exclusively with no foreign exposure could potentially make your trading experience more limited and riskier.
Bias to your company
Trading stock of a company you work for could be high risk even if you work for a very successful publicly traded company.
For example, in his study in 2001 Shlomo Benartzi found that Coca-Cola (KO) employees tend to invest three quarters of their contributions in their own company shares. In case of a KO stock downturn, the company’s employees would suffer from both a drop in labour income and in stock returns.
Bias to an asset you ‘like’
Many traders tend to invest in assets they like, whether it be stocks of a company whose products they like and use, or currency of a country they are familiar or fond of, etc. This could lead to neglecting to conduct the thorough research and analysis traders should commit to before trading any asset.
Avoiding familiarity bias
There are a number of techniques traders may find useful when seeking to avoid falling victim to familiarity bias.
Acknowledge the bias. Acknowledging the existence of familiarity bias is the first step to avoiding it. Traders may want to be aware of the potential for such bias to affect their decisions.
Research thoroughly. It may be useful to take time to research an asset before trading. This includes researching the background of the asset, understanding its fundamentals, and assessing its potential risks and rewards.
Seek insight from other traders. Traders could consider sharing insights and information experienced traders or financial advisors who may offer an objective opinion on the potential of the asset.
Take a step back. Before making a decision, traders should take a step back and assess the potential risks and rewards of the asset without allowing familiarity to cloud their judgement.
Keep records. Keeping a record of previous decisions and their outcomes could help to prevent familiarity bias from influencing future decisions.
Conclusion
Familiarity bias is a cognitive bias in which people tend to rely on information that is already familiar to them when making decisions. This means that they tend to prefer ideas, concepts, and people that they are already familiar with.
In trading, familiarity bias could lead to some traders giving preferential treatment to assets they have a personal connection to. Expanding their portfolio and gaining wider diversification, among other tactics, could reduce traders’ risk of falling prey to familiarity bias.
FAQs
What is familiarity bias in simple terms?
Familiarity bias is a cognitive bias where people tend to place a higher value on things that are familiar to them, potentially leading to an overestimation of their value or importance.
What is an example of familiarity bias?
An example of familiarity bias is when a trader prefers to buy stocks from companies in their home country, when similar stocks overseas may perform better.
What are the dangers of familiarity?
Familiarity could lead to traders making decisions or forming opinions based on what they already know, rather than considering all available evidence or alternative viewpoints.
How do you overcome familiarity bias?
It may be possible to overcome familiarity bias by being mindful of your decisions and analysing them objectively. It is important to evaluate all the available options, assess the potential outcomes and risks, and make decisions with objectivity.
Additionally, it may be helpful to involve other individuals or teams in the decision-making process to gain different perspectives and help identify potential bias.
