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 by 4% annually (i.e. from 1992 through 2016, the S&P 500 returned 9.9% annually, while family-owned business accounts investing in stocks earned 6.2% during the same time frame). This underperformance could be completely tolerable, as the diversification benefits of underperformance could still exceed the possibility of higher growth plus the heightened wipeout risk that would endure if all retained profits were subsequently reinvested in the business.

Additionally, there is a behavior finance justification for indulging familiarity bias. You can only be a successful investor to the extent that you can maintain your investments after a 40-60 price decline. Investing in local businesses that you can see and feel increases the chances that you will avoid selling (as the Dalbar study notes, investors from 1992-2012 earned less than four percent annual returns even though the S&P 500 itself performed more than double that).

Familiarity bias could be reckless if it is interpreted to mean, “I have heard of the company, therefore it must be a good investment.” Peter Lynch once used Ford stock as an example of how buying what you think you know can get you in trouble, as everyone has heard of Ford and it receives the most favorable investor attention during periods of global expansion (which is often succeeded by a cyclical cool-down in which the price of auto manufacturers fall).

Familiarity bias is only a penalty if you live in a city, country, or geographical zone completely devoid of businesses that earn double-digit returns. If you live in Missouri, there are fifty-seven publicly traded businesses that outperformed the S&P 500 from 2000 through 2015. Logically, you would only need to find one of them. Realistically, a handful of them would have been sufficient to give you what you need to get out of investing—dividends, interest, rental income, and the capital gains to fund what you want to get out of your lifestyle.

Originally posted 2018-06-22 01:20:32.

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