The familiarity bias or heuristic (rule of thumb) makes you invest in the familiar even though a less well-known alternative would produce a better return.
In simple terms this might mean investing in the shares of companies whose brands you know, rather than in better performing shares of companies you have not heard of. The result is likely to be lower returns, or even losses.
To counter the familiarity bias educate, yourself about the alternatives, compare the data on the different options and put in place a double-check reminder before investing in anything that sounds familiar. Take your time to decide based on full facts, rather than rushed choices.
Science of the familiar
A heuristic is a psychological term for a methodology used to make quick decisions. Humans use heuristics all the time to judge people and events, to form beliefs and to make decisions.
They are used to make fast choices in familiar situation but where there is uncertainty. Often heuristics are useful short-cuts to the right decision, quickly. If we hear gunfire, we duck. If it’s not gunfire we might look silly but, in general, ducking under fire is a good move.
But some heuristics lead to prejudice and to bad decisions, which is why they are often referred to as biases. A decision made too fast based on a preconception is not always the right decision.
Kahneman and Tversky
Israeli psychologists Daniel Kahneman and Amos Tversky worked together from the late 1960s. In 1973 they were the first to produce the idea of the availability heuristic or bias.
Their work between 1971 and 1979 eventually won Kahneman the Nobel Prize in Economics in 2002 (Tversky had died by then).
Between them they went on to develop prospect theory, which became vital in understanding how irrational decisions affect economics.
The premise of the availability bias is that people believe that if they can remember something easily, it must be more important than something they struggle to recall.
The problem is, we often remember what we have just seen more easily than we recall something not seen as recently. That means the things that are readily available get prioritised over alternatives that may have been better but not seen as recently.
Advertisers understand this and try to make sure their brands are constantly visible – more, at least, than their rivals’ brands. They know that will boost sales.
The familiarity bias extends the availability bias beyond the most readily available or most recently seen to the most easily remembered or most frequently used.
That’s a bit like brand loyalty. You continue to buy the same brands without even trying new ones. But it also means you stick with old firms without trying start-ups, even if the start-ups offer as good, or better, products without the legacy costs.
Investors might only put their money in stocks or with fund managers they have used before. Forex speculators might focus on the same currency pairs, rather than consider alternatives. The real risk is missed opportunity.
Avoiding familiarity bias
Rule one is not to rush investment decisions. Remember, heuristics are only ever useful for making quick decisions.
If you have time for more detailed analysis and to absorb more information, to consider outside factors and use more than your heuristic, you will make a better decision. That means carrying out fundamental analysis of the wider investment risks and opportunities.
Keep a record of your investment decisions and how they were reached and marry those with the resulting performance. Remind yourself which decision-making processes resulted consistently on the best results.
Count to ten before investing and use those ten seconds to ask yourself if you are sure there are not better alternatives available on the market.