Every country provides thousands of potential markets to trade: stocks, indices, mutual funds, etc. However, the world of investments is enormous and boundless. Sticking to just one single stock, sector or country limits your opportunities, making the risks higher.
The irrational tendency to trade only those securities which are familiar to you is called familiarity bias. Having a strong influence on your trading decisions, it’s a deviation in a trader’s behavior, which is better to be nipped in the bug.
What is familiarity bias and how do you fight it?
In a series of experiments, Amos Tversky and Chip Heath showed that people, when faced with a choice between two gambles, were likely to pick the one which seemed familiar. Gur Huberman went further, adding that "familiarity is associated with a general sense of comfort with the known and discomfort with, even distaste for and fear of, the alien and distant."
People tend to believe in assets they’ve heard about, even if it’s just the name of their favourite pizza brand. Typically, they have little to no reliable data or forecasts about the stock’s performance.
A strong belief that familiar investment alternatives are safer and less risky to invest in is a psychological bias that impacts your decisions as an investor. It makes you underestimate the potential risks of trading a limited number of stocks, disregarding one of the most crucial risk management tools: portfolio diversification.
Familiarity bias implications
Taken in by the familiarity bias, you often end up taking on more risk than desired. This widespread behavioral bias has several implications, including the following:
Undiversified asset allocation
Trading just one or several stocks
Preferring stocks of your home country (equity home bias)
Preferring stocks that seem close to your cultural level
Preferring stocks that are close to your professional activity
If you do recognise some of these behavioral patterns in your trading experience, you should face your “enemy” and fight the familiarity bias, which impedes your success as a trader.
Equity home bias
The phenomenon that many traders’ portfolios are much more focused on local (domestic) equities has bothered experts for years. According to financial theory, international diversification may significantly help to reduce trading risks, without affecting the expected returns. However, this bias may be remarkably pervasive and persistent. Concentrating on investments in equities of their home countries, investors fail to use the potential benefits of the international equity diversification.
Home bias was first described by the academicians James Poterba and Kenneth French in 1991 in their work “Investor Diversification and International Equity Markets”. Today, with the technological innovations and outstanding online trading platforms, it is much easier to search for and invest in overseas equities.
Though the familiarity and equity home bias as one of its forms still exists, the situation is gradually improving. According to some statistics from the “Global Political Economy: A Multi-Paradigmatic Approach” by Kavous Ardalan, in 1989 US traders held 94% of their investments in domestic equities, and UK traders had 82% of their portfolios invested in British local stocks.
Today, the figures look much better, with home-based portfolios accounting for 50% in the USA and only 25% in the UK.
How to fight familiarity
If you want to take adequate investment decisions and build a safe and sound portfolio, you’d better estimate the potential trades on some more reliable financial grounds than your gut feeling. Choosing equities closer to home means that you miss out on so many attractive trading opportunities abroad.
Today’s interconnected world is not about separate countries and their local assets. It’s all about diversification and enormous opportunities everywhere. Don’t let any bias to drag you back.
eQ by Capital.com detects behavioural patterns and biases as you trade.