Familiarity bias: the danger of sticking to what we know

A common piece of advice given to aspiring authors is to write about what you know. The idea here is that by tapping into your own experience, you make your work more authentic and engaging. When it comes to investing, so-called familiarity bias can be a big problem. Those who restrict their portfolio to the familiar can limit their returns and add unnecessary risk.

In behavioural finance, there is a term for a tendency among investors to put their money only into companies they have heard of. It’s called "familiarity bias" and it is one of the toughest psychological nuts to crack. Even professional investors succumb to it.

On one level, wanting to stick to the familiar is an understandable impulse. Just as people tend to support their local football team, they often prefer stocks they know. After all, there tends to be much more information readily available about domestic stocks. We see those brands around us each day and build up a level of understanding about the business they are in, their products, reputation, management and outlook.

On another level, however, a failure to cut the metaphorical apron strings in your portfolio can leave you missing out on opportunities you might otherwise never have heard of. It can also leave you over-exposed to certain industries, sectors and economies, and under-exposed to others.

Home market bias

For example, the UK equity market makes up about 4% of global market capitalisation. Canada and Australia each represent a little over 2% of the global market. Yet it is common to hear of individual investor portfolios with 60% or more of their equity allocation dedicated to the domestic markets of those countries.

Sector allocations also differ markedly from country to country. The starkest example is in information technology (Apple, Microsoft etc) which represented nearly a third of the US market as of the end of March, compared to less than 2% in the UK and Australia.

On the flipside, materials stocks (companies which discover, develop and process raw materials — like BHP Group) make up more than a quarter of the Australian market, well above weights of just over 10% in the UK and less than 3% in the US.

For the UK, the single biggest sector is consumer staples — think brands like Unilever, Diageo and Tesco — which make up almost 20% of the MSCI UK index, compared with just 5-6% in the US and Australia.

Given this disparity in sector weights and given the benefits of diversification, it makes sense, then, to not stay be overly focused on one market.

Rational reasons for home bias

This doesn’t mean, of course, that one cannot emphasise your home market. There can be tax reasons for weighting one’s portfolio to domestic equities and bonds. Similarly, uncertainty over currency movements, and cost of hedging, could justify a home tilt.

But these need to be conscious and deliberative decisions, not sentimental ones. Behaviouralist economists say the danger is in people extrapolating from the idea that because they are familiar with certain names, that makes them less risky.

Supporting this view is research showing that despite their familiarity with domestic names, local investors are no better than international ones in predicting earnings surprises. Neither do they show any tendency to outperform due to home bias. The information advantage they feel they have does not tend to translate into better results.

Other types of familiarity bias

But familiarity bias does not just exhibit itself in a tendency to favour domestic over global equities. A common mistake is to over-invest in the company that employs you, thus staking both your human capital and financial capital on a single name.

Commonly cited examples are ill-fated firms such as Enron or Lehman Bros, where many employees had significant retirement savings locked up in the companies’ stock. This meant when bankruptcy hit, they lost their job and their investments.

A vague sense of patriotism or a wish to support local industry can also breed familiarity bias. A suggested response here is to realise that many large domestic companies source a chunk of their earnings from global markets. So if local companies are going global, surely investors should too.

Start global

At the end of the day, all of us suffer from familiarity bias by nature, but there are things we can do to combat it.

A good idea is to use the global market as a starting point and then tilt away according to your individual goals, tastes, preferences and circumstances. As we have seen, there may well be a reason for home bias based on preferential taxation or regulatory costs and other frictions that stand in the way of investing internationally.

But these arguments need to be set against the risk-spreading benefits of global diversification and the access that this gives to economic forces and sources of return that are not easily available in the home country.

The more sectors and companies you invest in, the less exposed you are to idiosyncratic or uncompensated risks associated with a single name. Likewise, the more countries you invest in, the wider your exposure to different economic cycles.

Ultimately, when it comes to investing, there is a whole world of opportunity out there.