Familiarity Bias in Investment
Investment involves picking up the most suitable instrument capable of generating income over a period. As investing is a process of acquiring a financial asset by parting the hard earned money, the investment decision is always believed to be a rational decision. In reality, the individual biases and values override judicious decision making. In real life, a person may opt for a particular brand of cloth even if clothes of better quality at better prices are available in other brands. The person might be apprehensive to select a new brand of cloth as he is unfamiliar with the brand and hence the decision making becomes uncomfortable. Similarly, familiarity clouds decision making during investment and an investor often tends to buy investment product familiar to him. The behavioral bias that prompts an investor to stick on with a known investment product is termed familiarity bias.
Why is familiarity bias dangerous in investment?
An investor working in a bank opting for mutual fund scheme with focus on banking sector or a person in manufacturing sector opting for a sectoral / thematic equity mutual fund investing in manufacturing sector can be described as influenced by familiarity bias. In such a scenario, any impact on the segment in which invested can lead to dual risk. For example, when the manufacturing sector undergoes a downturn, both the job and investment will face challenges.
What is the root cause of familiarity bias?
Familiarity bias arises from two causes; over confidence on his own awareness level and loss aversion bias. An investor always tends to be overconfident on his own decisions and his own field of expertise. This makes him confine to his area of familiarity and prevents from venturing out of comfort zone. Familiarity bias is often the result of investor trying to be his own financial planner. This bias often leads to the investor buy stock of own company or country and prevents taking advantage of developments in other fields.
What is the drawback of familiarity bias?
Familiarity bias impacts the investor portfolio in many ways. It prevents diversification and thus makes the investment prone to risk associated with a particular sector. Asset allocation will be within one sector which makes the investment portfolio inferior. Hesitation to explore available opportunities ends up in missing better returns. Familiarity may prevent the investor from carrying out research and analysis and the investment may become loss making.
Steps to overcome familiarity bias
The first step in overcoming familiarity bias is bringing in a change in mental set up. Investors must accept that familiarity need not always yield the best result. Investors should put in a mechanism for period assessment of performance of their portfolio against a benchmark. This will enable them to realize the potential of missed opportunities and recalibration to be made in the portfolio. Always alert eyes and ears only will help an investor to overcome familiarity bias.
