Often, we’re inclined to buy local or to go with something that we’re familiar with. Take produce, for instance – if there was a local farm you had visited, you’d probably be more likely to purchase food from there over an unknown source from the supermarket.
This is a psychological phenomenon known as the familiarity bias. While this bias sometimes makes sense when it comes to buying vegetables or picking a restaurant, avoiding familiarity bias is absolutely essential when it comes to investing.
How does familiarity bias play out in investing?
Just like we’re more comfortable and likely to eat at certain restaurants, we’re drawn to invest in certain companies that we have an intimate familiarity with. One very prevalent example of this is employers. Because investors spend day in and day out at their workplace, that familiarity can lead them to invest much of their wealth into that company.
The truth is that no matter how familiar you are with a company, you’d most like be better served by avoiding familiarity bias. Despite any intimate knowledge you have, diversification is one of the essential elements of a successful long-term strategy. By concentrating your investments into one asset, you’re taking one more risk while lowering your chances of higher returns. That’s not to mention that your inside knowledge of a few aspects of a company is likely to be extremely uncorrelated with the actual performance of the firm (unless you happen to be the CEO).
Avoiding familiarity bias with global diversification
This bias is also likely to play out through a lack of global diversification. Because we’re more familiar with the political and economic factors at play in the US (and unfamiliar with those of other countries), we’re more inclined to invest solely in domestic stocks. The truth is that almost half the world’s stock market capitalization is located outside the US, and despite our lack of familiarity, these investments can be a great element of diversification. When US stocks are down, global markets can be up, and vice versa.
Our approach to avoiding familiarity bias
At LexION Capital, one of our core tenants of investing is being globalized. We will scour the entire globe to find the best investments for your goals and needs. We also utilize our decades of experience and academic research to focus on diversified portfolios for our clients. If you would like to learn more about our approach to investing and our services, don’t hesitate to contact us and speak with one of our fiduciary advisors today.