What Is Familiarity Bias How It Works
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All about familiarity bias
“Investor’s chief problem and his worst enemy is likely to be himself.” – Benjamin Graham
Understanding the Role of Familiarity Bias in Investment Decisions
While many of us like to believe that we make rational decisions, we often disregard the significant role that feelings and emotions play. This misconception extends to investment decisions as well. Contrary to popular belief, our investment choices are not always perfectly rational; they are often influenced by various behavioral biases, such as familiarity bias. See below for the What Is Familiarity Bias How It Works in detail.
What Is Familiarity Bias How It Works
Everyday Examples
Familiarity bias can be observed in our daily lives. Whether it’s sticking to a few favorite dishes on a menu, frequenting the same shopping center, or taking the same route to work, this bias manifests in our preference to stay within our comfort zones. Our minds resist change and prefer familiar scenarios.
Impact on Investments
In the context of investing, familiarity bias discourages us from exploring unfamiliar assets or investment options. Consequently, our portfolios may lack diversification, causing us to miss out on potentially higher returns. A common example is the over-allocation of investments in debt assets like fixed deposits and Public Provident Funds (PPF), with little to no exposure to the equity market. Many investors follow this pattern because it mirrors the investment habits of their parents and grandparents.
Causes of Familiarity Bias
Loss Aversion
One of the primary reasons behind familiarity bias is loss aversion. Investors tend to avoid losses, which confines them to their comfort zones.
Herd Mentality
Decisions influenced by the actions of others also contribute to this bias. The tendency to follow herd mentality can prevent investors from making decisions that are best for their individual circumstances. While one investment strategy might work for some, it might not be suitable for everyone.
Availability Bias
Availability bias also plays a role, as we have more information about options we are already familiar with, making it easier to stick to them.
Effects of Familiarity Bias
Missed Opportunities for Higher Returns
Investors who heavily invest in fixed deposits are often missing out on the potential for higher returns that equities might offer in the long run. By avoiding risks, they overlook opportunities for greater gains.
Inadequate Diversification
A well-diversified portfolio reduces overall risk and can yield better returns. However, due to familiarity bias, investors tend to stick to known asset classes and stocks, increasing the overall portfolio risk.
Insufficient Research
Investors may neglect adequate research when investing in familiar products or stocks. This lack of due diligence can lead to losses, as familiarity does not guarantee profitability.
Overcoming Familiarity Bias
Regular Portfolio Evaluation
Regularly evaluating your investment decisions can help mitigate the effects of familiarity bias. Ensuring the right asset allocation and diversification is crucial.
Objective Portfolio Rebalancing
Maintaining objectivity is key. Evaluate your portfolio from a distance to make necessary adjustments, such as reducing allocations to underperforming stocks or exploring new investment options.
Stepping Out of the Comfort Zone
While challenging, stepping out of your comfort zone is essential to keeping familiarity bias at bay. Actively seeking unfamiliar investment options and objectively rebalancing your portfolio can lead to more informed and profitable investment decisions.
By understanding and addressing familiarity bias, investors can make more rational decisions, leading to a diversified and potentially more profitable investment portfolio. This is the brief information abou the What Is Familiarity Bias How It Works in detail.
