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Familiarity bias impacts portfolio diversification from "summary" of Beyond Greed and Fear:Understanding Behavioral Finance and the Psychology of Investing by Hersh Shefrin
Familiarity bias can have a significant impact on the way investors choose to diversify their portfolios. This bias refers to the tendency for individuals to prefer investing in assets or securities that they are familiar with, rather than branching out and exploring new opportunities. This can lead to a lack of diversification in a portfolio, as investors may choose to allocate a disproportionate amount of their assets to a small number of familiar investments. When investors exhibit familiarity bias, they are essentially limiting their exposure to different asset classes and industries. This lack of diversification can increase the overall risk of the portfolio, as it becomes overly dependent on the performance of a few select investments. In the event that these investments underperform or experience volatility, the entire portfolio could be negatively affected. One reason why familiarity bias impacts portfolio diversification is rooted in the psychological comfort that investors derive from investing in familiar assets. Familiarity provides a sense of security and control, as individuals believe they have a better understanding of the risks and potential returns associated with these investments. This perceived sense of knowledge can lead investors to overlook the importance of diversification and instead focus on maintaining a sense of familiarity within their portfolio. Another factor that contributes to familiarity bias is the cognitive ease associated with investing in familiar assets. Research has shown that individuals are more likely to invest in assets that are easily recognizable and require less cognitive effort to evaluate. This can create a bias towards investments that are well-known or commonly discussed in the media, while overlooking opportunities in less familiar or niche markets.- Familiarity bias can hinder investors from achieving optimal portfolio diversification by limiting their exposure to a wide range of assets and industries. By recognizing and actively working to overcome this bias, investors can construct more resilient portfolios that are better equipped to weather market fluctuations and achieve long-term financial goals.
