By Laura Tanner, Ph.D., CFP
Learn more about Laura on NerdWallet’s Ask an Advisor
It’s long been established that individual investors tend to do worse than the overall stock market. A big reason for this is that all of us have behavioral biases that can affect our ability to act objectively when it comes to trading. As Benjamin Graham, the famed proponent of value investing and author of “The Intelligent Investor,” put it: “The investor’s chief problem — even his worst enemy — is likely to be himself.”
In particular, “familiarity bias” can lead investors down the wrong path. Do you know people who eat at the same restaurant every time they go out for dinner? That’s familiarity bias. They stick with what they know and avoid what they don’t know. This mindset may be harmless (though perhaps boring) in everyday life, but it can be terrible for your investments — with implications beyond simply substandard returns.
Here are a couple of examples of what familiarity bias might look like in a portfolio.
Being overinvested in your employer
It’s easy to think, “I know my company — what could go wrong?” You may work at a tech company with a long-term incentive plan that offers you equity. Or maybe your employer’s 401(k) plan includes company stock, either as an elective investment or as the company’s matching contribution.
But just because you believe in the company doesn’t mean things can’t go wrong. I know this firsthand from my own experience at a biotech company. In a short period of time, the stock price dropped from $60 a share to less than $10. Any employees who held a significant number of company shares suffered a large loss.
The Enron scandal provides a well-known example. That company’s executives and accountants were manipulating the books to make the firm seem vastly more successful than it was. When it all came to light, the company collapsed into bankruptcy in 2001. Employees with significant amounts of now-worthless Enron stock in their 401(k) plans suddenly weren’t sure they could ever retire. One employee in his mid-50s at the time saw his retirement account drop from $470,000 to $40,000.
Investing only in the U.S. stock market
In the past several years, the U.S. stock market has represented just 35% to 50% of the global equities market, and yet, many investors invest exclusively in U.S. stocks. In this case, familiarity bias denies these investors the benefits of diversification. There are periods when international stocks are uncorrelated with U.S. stocks, meaning foreign stocks do well when domestic stocks perform poorly, and vice versa. Owning both helps smooth out the long-term performance of portfolios.
The table below shows how major U.S. stocks (represented by the S&P 500 index) and international stocks (the MSCI EAFE index) performed for the period 1991-2013. From 2003 to 2007, for example, international stocks generated a higher return than U.S. equities. The differences illustrate why it helps to have both foreign and domestic investments in your portfolio.
|Performance by year (each year’s better performer in bold)|
|S&P 500||MSCI EAFE|
Source: CBS Money Watch
To overcome familiarity bias, make sure you are not overly invested in your company’s stock. If you are, shift some of your allocation to other investments if possible. Ask yourself: If you inherited a lump sum of money, would you choose to invest all of it in company stock? (The answer should be no.) Also remember that you diversify your portfolio when you invest in international markets in addition to the U.S. Doing so will reduce volatility over the long run.
We all have biases. But the more we recognize and understand the ones that prevent us from making good investing decisions, the better off we’ll be.
This article also appears on Nasdaq.
Image via iStock.