When I was ten years old, I decided that I wanted to purchase my first stock. Of course, a ten-year-old can’t just go to a stockbroker. So, I enlisted the help of my grandma to scour the pages of the Wall Street Journal for what was surely going to make me a child investing prodigy. Exactly how does a ten-year-old decide what stock he wants to buy? Well, this was the 1990’s and light-up shoes called LA Lights (manufactured by the publicly traded shoe company L.A. Gear) were all the rage. Their magic was a light in the heel that lit up every time the wearer stepped down. They were awesome, as you can see clearly displayed by this 1994 commercial: YouTube: LA Lights, “Leave The Lights On”. All the cool kids owned a pair, which guaranteed my parents didn’t buy them for me. So, in one of the more bizarre displays of pre-teen rebellion, I decided to buy a part of the company (even if a miniscule fraction).
Almost immediately, (to your surprise, I know) L.A. Gear filed for bankruptcy[i] and my investment was reduced to nothing. Now, I didn’t have cool shoes, or the stock! I did, however, have the unique distinction of being the only kid on the playground who got to participate in the class action lawsuits that followed. How’s that for recess?!?
How could I have been so wrong? Where did my deep fundamental analysis lead me astray? As it turns out, I exhibited the tell-tale trait of familiarity bias. As the name implies, investors tend to bias towards what they know when making decisions about their portfolio. For example, if you see a lot of Tesla vehicles on your drive to work you may be inclined to believe that the stock is a winner and you should go buy a few shares. While this observation does potentially imply that the business is doing well, it doesn’t really tell us anything about the fundamentals of the company, its future profitability, or if the stock is currently over or undervalued.
In my case, how could L.A. Gear not be a winner? Anyone who walked down a hall of King Elementary School in Akron, Ohio circa 1997 would see it light up like a Christmas tree with every heel strike. It was a slam dunk. In reality, the company was bleeding cash, had recently laid off 60% of its workforce, and defaulted on debt payments.
In addition to the familiarity bias, it turns out our brains use all kinds of short-cuts and biases to sub-optimally solve problems as quickly as possible. These short-cuts are called heuristics, and we all use them subconsciously on a regular basis. Familiarity bias is one of many cognitive biases investors fall prey to when they face complex problems or incomplete information. Interesting note: Cognitive biases also have a significant impact in the world of aviation. Many airline-pilot processes and checklists are designed to effectively utilize positive mental short-cuts as well as avoid heuristics that may cause a dangerous situation in-flight. (See article by William Tuccio at Embry Riddle Aeronautical University – Heuristics to Improve Human Factors Performance in Aviation.)
In investing, familiarity bias will typically manifest itself in a portfolio with a lack of diversification. As a reminder, diversification is the concept that investing in a broad portfolio of stocks (or any other asset class) can help to reduce idiosyncratic (or company-specific) risk and volatility in a portfolio. It is sometimes referred to as, “the only free lunch in investing.” Inevitably, investors who prefer to only buy investments with which they are familiar will pile into fewer stocks. However, the U.S. stock market alone has over three thousand companies that are publicly traded. Purists of diversification would say that you should own all of them (plus international companies). For an investor biased towards familiarity and making investment decisions based only on what they know or observe in their daily routine, the universe of investable assets shrinks considerably.
In today’s market dynamics, familiarity bias can also manifest itself in seemingly diversified, well-known indices such as the Dow Jones Industrial Average (DJIA), S&P 500 and NASDAQ. When the news media reports on the daily “market” performance, these are the benchmarks typically referenced. As a result, many investors have become exclusively familiar with the DJIA, for example, and equate it to “the market.” However, the DJIA represents only 30 U.S. companies, so if an investor decides to only own that index, his portfolio would be woefully under diversified. Even if they invest in the S&P 500 (the 500 largest stocks in the U.S., with some caveats), they would be far more concentrated than the name implies. While a holder of the S&P 500 technically owns over 500 stocks, the weighting is by market capitalization. As a result, the biggest companies command a far greater percentage of the index, thus limiting diversification benefits.
As of November 9, 2023, the top ten holdings of the S&P 500 represent almost 31% of the entire index.
Source: Yahoo Finance, SPDR Portfolio S&P 500 ETF (SPLG), accessed 09 Nov 2023.
Another important consideration to keep in mind is that the well-known indices (DJIA, S&P 500, NASDAQ) concentrate on the largest U.S. companies (typically referred to as large cap companies). To increase your portfolio’s diversification and potentially reduce its volatility, also consider allocating a portion to international and small-cap stocks. Doing so may help increase the diversification in your portfolio. As the illustration from Dimensional Fund Advisors highlights below, the best performing sector is incredibly volatile from year-to-year. An investor who exhibits familiarity bias with exposure to only one or two sectors could risk long stretches of underperformance.
What are some ways to prevent familiarity bias from negatively impacting your portfolio? Most importantly, when evaluating your investments, if you hold greater than five percent in any one stock or company, it’s probably a good idea to consider trimming the position. If you own it in a tax-deferred or exempt account, this is a fairly easy exercise with likely no tax implications. However, if the holding is in a brokerage account, look for opportunities to tax loss harvest positions with losses and offset those losses by selling concentrated positions with embedded capital gains. Ultimately, if you enjoy stock picking and investing in familiar names, consider creating a “play account” with a sum of money that you can afford to lose (similar to going to Vegas to gamble). The remaining amount should be invested in a well-diversified portfolio of low-cost mutual funds or ETFs.
If you invest in your company’s stock purchase program or in your airline’s profit-sharing account, your investment portfolio as well as your human capital will be highly concentrated in your airline. Proceed with caution and brush up on your airline’s bankruptcy history. If (when) your airline experiences a slowdown and turns to furlough for relief, it likely means their stock has also taken a beating, thus providing a double whammy to your total portfolio. The most extreme example in recent memory is Enron employees in the early 2000s. When the company went under, many of its workers had a large part of their retirement savings tied up in Enron stock, exhibiting an unfortunate outcome of familiarity bias. When the company went under, any potential of a safety net from their retirement savings was also wiped out.[ii]
If you find you are exhibiting tendencies of familiarity bias, ask yourself why you are investing in a particular stock or index. If your answer is simply because it’s a product you know well (Apple, Netflix, etc.), consider whether this truly makes it a good investment. Additionally, if it’s a well-known company, you probably already own some of it in your other mutual funds or exchange-traded funds (ETFs). See the top holdings of the S&P 500 above as an example.
When it comes to the familiarity bias, I learned my lesson the hard way. Fortunately, making investing mistakes at age ten gave me plenty of runway to recover. For those with a little less runway, combating this bias can help lead to a better investing outcome and reduced risk in a portfolio. For those of you who want to explore these and other behavioral biases in more detail, check out this article from the Harvard Business Review. This article also includes a 32-question assessment that is meant to help executives and high-performance professionals make better decisions and minimize the negative effects of human behavioral biases similar to the familiarity bias.
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