Investments: beware of things that seem too familiar

In addition to the many parameters requiring consideration, in order to invest well, it is important not to overestimate your skills, knowledge or influences. But did you know that it is also key to watch out for things that you think you know or have mastered? By investing too heavily in things that seem familiar to us, we run the serious risk of inadequate diversification and thus risk concentration.

Investing is always a complex decision-making process made up of strategic choices and delicate trade-offs based on your investor profile and life goals. This is one of the reasons that myLIFE regularly encourages you to invest with the help of professionals, unless you have the time and skill to do it yourself.

Alongside rational considerations, emotions also play a role when investing, and behavioural economics teach us that emotions are not always the best source of advice. This is particularly the case when they exert such an influence on our brain that we are sometimes unaware of what is driving our actions.

Familiarity bias

In everyday life, we all have our preferences: dark or milk chocolate, one brand of clothes rather than another, one sports team rather than its greatest rival. Our preferences result from a clever mix of our personality traits, background, values and the emotions that these arouse in response to events in our lives. Nothing could be more straightforward! However, these preferences can become so ingrained as to make us ignore objective criteria that should influence our choices. For example, you may remain loyal to one type of smartphone, even though it is not the best performing phone on the market and has risen substantially in price. You continue to support your preferred team, even when its results are poor. In reality, you don’t consider changing because, deep down, you are reassured and comforted in your identity by sticking to your usual choices.

Our pervading preferences hide a well-established cognitive pattern. When it comes to making a decision, our brain prefers what it knows, both because this is reassuring and because it economises cognitive resources. We are often unaware of this pattern, which guides us towards the comfort of the known rather than towards the discomfort and risk of the unknown. However, there is a cost attached to this cognitive comfort: we underestimate the downsides associated with making familiar choices and ignoring new and potentially more rewarding alternatives.

There is a name for this cognitive phenomenon: familiarity bias. It refers to our tendency to prefer familiar options and to ignore – consciously or unconsciously – alternatives, simply because they are new or unknown.

Familiarity bias refers to our tendency to prefer familiar options and to ignore – consciously or unconsciously – alternatives, simply because they are new or unknown.

Familiarity in investment

Spontaneously, it may seem wiser to prefer what we know or think we know. This is true, providing this tendency does not work against us and make us blind to certain risks. And this is precisely what is at stake when investing. Familiarity bias is a potent force that encourages us to invest against our own interests by excessively focusing on things that we think we know. When investing, this bias can manifest itself in a variety of ways:

• • focusing exclusively on purchasing the shares of local or domestic companies or those in a single region;
  • investing solely in companies in a sector we are familiar with or where we have experience; or
  • banking solely on the shares of companies or brands that we know.

By restricting diversification, familiarity bias exposes investors to unnecessary risks, and sometimes they are even unaware of this. For example, techies may spontaneously tend to construct a portfolio in which the technology sector is overrepresented. Even if this portfolio is diversified geographically, history shows that this will not necessarily provide protection from a speculative bubble. Indeed, in a global world where there are very many complex interconnections between sectors and economies, it is harder than it looks to ensure diversification when investing.

Even developed markets may be characterised by the predominance of a few large companies in a regional stock exchange index. This is what we call concentration risk. In the last quarter of 2023, the ten largest companies listed in the FTSE 100 in the United Kingdom represented close to 45% of the total market capitalisation. This highlights the fact that diversification can be much lower than an inexperienced investor may believe.

Familiarity bias may also have dramatic consequences when we bank everything on what we believe we know best. Whilst diversification represents a major challenge for entrepreneurs who tend to invest all of their assets in their own company, it is not easy to ensure for employees either. In the US, millions of Americans invest for their retirement via 401(k) plans. Introduced at the start of the 1980s, employees can invest a limited portion of their earnings before tax directly in 401(k) plans. This system is all the more attractive as employers often pay a part or even all of this contribution.

Familiarity bias may have dramatic consequences when we bank everything on what we believe we know best.

Whilst employees can choose from a variety of investment options, generally mutual funds, many opt for an investment in the shares of their own company. This seems an easier option and provides reassurance, as they have the impression (which is not always well-founded) that they know how solid their own company is. Yet this lack of diversification can have dramatic effects, as the case of Lehman Brothers in 2008 illustrated. When bankruptcy hit, employees lost their jobs and some of them also lost their retirement savings.

Yet spreading concentration across a sector rather than a single company does not necessarily provide full protection for an investor. Anyone who banked everything on real estate in the US and suffered the consequences of the subprime crisis is well placed to know this. To a lesser extent, anyone who believed in the illusion that prices could not fall and invested everything in Luxembourg real estate had a rude awakening in 2022.

What are the key takeaways? Don’t put all your eggs in one basket is a good start, don’t bank everything on eggs from the same farm or the same type of hen is better!

Don’t put all your eggs in one basket is a good start. Don’t bank everything on eggs from the same farm or the same type of hen is better.

By being aware of the existence of familiarity bias and seeking to actively diversify across sectors, asset classes and regions, investors can improve the resilience of their portfolio and its long-term potential.

A few hints on how to combat familiarity bias

Everybody is influenced by familiarity bias. Ignoring it when investing not only increases risk, it also raises the likelihood of missing growth opportunities in sectors or markets with which we are less familiar. But how can we combat this? There are tools and strategies to try and eradicate this impediment to growth in your investment portfolio. The main ones are as follows:

• 1. Force yourself to diversify your portfolio. By diversifying your investments across sectors, regions and asset classes, you reduce the impact of familiarity bias. Even if we have seen that diversification can be a complex matter, this approach minimises your dependence on a single investment, whilst increasing your exposure to other potential opportunities.
  2. Actively seek out reliable information about investments that are outside your comfort zone. By exploring new sectors or markets, you can expand your knowledge. This will enable you to make better-informed decisions and identify new opportunities.
  3. Get help from experts. Financial advisers are there to support you and to provide recommendations that will allow you to diversify your portfolio whist taking account of your risk tolerance, objectives and investment horizon.
  4. Examine and rebalance on a regular basis. Examine and rebalance your portfolio regularly – this will help you detect any overconcentration of risk and ensure diversification, whilst providing assurance that your portfolio still meets your investment objectives. If this level of work seems too cumbersome, why not consider discretionary management services, which involve your bank receiving a mandate to manage your assets in your name and on your behalf, in accordance with an investment strategy defined with you in advance.

If you want to invest better, learn to avoid your familiarity bias!