A famous Wall Street adage suggests to “invest in what you know”, and many investors follow. But what if investing only in “what you know” means throwing away other attractive trading opportunities for higher profits and lower risks?
Investors’ preference for familiar assets in the presence of unfamiliar assets with lower risks and bigger potential returns is known as the familiarity bias.
Familiarity bias and lack of diversification
Why do traders and investors continue compiling and managing portfolios, consisting mainly of familiar assets, despite the obvious advantages of diversification? Wishing to stay inside their comfort zone, they are not ready to walk the road less travelled.
Inclination towards familiar stocks makes them invest in their own country, the company they work for or the companies they simply “like” and whose products they use.
Reasons why traders fall into the familiarity bias
There are several reasons why investors may suffer from the familiarity bias. Some are afraid of seeking help or financial advice, choosing their own way. Others try to avoid losses by staying in their comfort zone and avoiding diversification as something unfamiliar and unknown. It may also come from the availability of information about the stocks and companies you know.
The one thing you should always remember is that familiar doesn’t mean safe.
When your asset allocation is restricted only to familiar stocks, your portfolio becomes inferior. Failing to diversify, you end up losing potential opportunities to try and profit from something new. Without proper research and analysis you may end up opening some losing trades that could be avoided.
How to overcome the familiarity bias
The best remedy for familiarity bias investing is diversification. To overcome this weakness, you should attempt to reduce your investments in domestic stocks, familiar companies and companies you work for.
Even if you’re an IT specialist with a deep knowledge of the tech sector, try to look outside of the box and consider other industries, like finance, retail or life sciences. I’m sure you will find plenty of new outstanding businesses with positive financial reports and optimistic analysts’ forecasts regarding their stocks’ future.
Once you’ve chosen a stock to trade, remember that it should be carefully analysed without any form of bias. Measure the potential risks and rewards beforehand, as objectivity is your best friend here. A successful trading experience is always rational and logical. Don’t let behavioral biases overrule your trading decisions.