Familiarity bias in investing refers to the preference for investing in familiar assets, such as local stocks or industries well-known to the investor. Below is an exploration of this investment bias’ tendency to overinvest in familiar assets, the risks associated with a lack of diversification due to familiarity bias and strategies to expand investment horizons beyond familiar territories.
THE TENDENCY TO OVERINVEST IN FAMILIAR ASSETS
Familiarity bias leads investors to gravitate towards investments within their comfort zone, such as local companies or sectors they have experience with. This preference stems from a natural human inclination to stick with what is known and understood. For instance, an investor might prefer to invest in the stock of the company they work for or in industries prevalent in their region, assuming they have better insights into these areas.
While investing in familiar territories can seem less risky, it often stems from a subjective sense of comfort rather than objective analysis. This bias can also be reinforced by the echo chamber effect, where investors are surrounded by similar thinking and information sources, further validating their choices.
RISKS ASSOCIATED WITH FAMILIARITY BIAS
The primary risk of familiarity bias is the lack of diversification. Diversification is a fundamental principle of investing that involves spreading investments across various asset classes and geographies to mitigate risk. Overinvesting in familiar assets can lead to an undiversified portfolio, which is more susceptible to local market fluctuations and sector-specific downturns.
For example, if an investor's portfolio is heavily weighted towards local companies, a downturn in the local economy could have a disproportionately negative impact on their investments. Similarly, investing predominantly in a single sector ignores the potential benefits and risk mitigation offered by other sectors or global markets.
STRATEGIES TO EXPAND INVESTMENT HORIZONS
To overcome familiarity bias and achieve a diversified investment portfolio, investors can adopt the following strategies:
Education and research: Educating oneself about different asset classes and global investment opportunities can help in making informed decisions beyond familiar territories.
Objective analysis: Evaluating investments based on objective criteria such as performance metrics, risk factors, and growth potential, rather than personal familiarity or comfort.
Professional advice: Consulting with financial advisers can provide insights into a broader range of investment opportunities and assist in building a diversified portfolio.
Gradual exposure: Gradually expanding investment horizons by initially investing small amounts in unfamiliar assets can help investors become more comfortable with these investments over time.
Regular portfolio reviews: Periodically reviewing and adjusting the investment portfolio to ensure it aligns with diversification goals and is not overly concentrated in familiar investments.
Familiarity bias can lead investors into the 'local investment trap', where overreliance on familiar assets hinders portfolio diversification. Recognising this bias and adopting strategies to broaden investment horizons are crucial for building a well-diversified portfolio that balances risk and reward effectively. By stepping out of the comfort zone and exploring a wider range of investment options, investors can achieve a more robust and resilient investment strategy.
This Trustnet Learn article was written with assistance from artificial intelligence (AI). For more information, please visit our AI Statement.