Justifying Familiarity Bias in Investing

“[Familiarity] bias occurs when investors have a preference for familiar investments despite the seemingly obvious gains from diversification. Investors display a preference for local assets with which they are more familiar (local bias) as well as portfolios titled toward domestic securities (home bias). An implication of familiarity bias is that investors hold suboptimal portfolios. To overcome this bias, investors need to cast a wider net and expand their portfolio allocation decisions to gain wider diversification and risk reduction. Investing internationally helps to avoid familiarity bias.” – H. Kent Baker and Victor Ricciardi, “How Biases Affect Investor Behavior”.

When a family-owned business reinvests its earnings into its own business, it earns a 12% return on book value (this is the historical average for closely-held business according to Ibottson from 1926 through 2012). And yet, when a family-owned business takes its earnings and reinvests the money into the stock market, it underperforms … Read the rest of this article!