When was the last time you ordered a brand-new dish at your favorite restaurant? I ask because I've noticed that there is a spectrum from adventurous to fearful when it comes to the people I often dine with. I'm the adventurous type when it comes to gastronomical allocations. Sure, I've been burned before, both literally and figuratively. But on the average, I've enjoyed discovering new things more than I've regretted it.
One friend of mine will peruse the menu and wax eloquent about how different menu items sound delightful. But when the waiter takes our order, he flinches and orders the same thing he always orders. I roll my eyes and goad him into trying something new. The fear of a bad meal outweighs the familiarity of the same old, same old he's always had.
To fix this conundrum for both types of diners, restaurants should offer more “sampler” plates, a combination of several menu items, albeit in smaller portions. That way if 1 of the 3 things you order is a loser the others can make up for it.
My friend suffers from a food familiarity bias. He goes with the known. With food, it's not a big deal, but when it comes to investing familiarity bias can have serious consequences. Let me share a few examples:
Our values in life are formed by how we are raised as much as anything else. When our family has a history with a company, there is a large amount of familiarity. These company stocks can be blue-chips that pay a nice dividend that grandma owned for years. Sometimes these equity positions are purchased because dad worked at the company and they took really good care of him.
Clients with a familiarity bias tend to want to own the stock forever with no plan to reduce the allocation. Is their desire because the stock fits their asset allocation model? Nope. Do they want to keep the stock because they are carefully considering the tax implications of a stepped-up cost basis on inherited stock? Not at all. They want to keep the stock because it's familial and familiar.
You spend as much time or more each day at work than you do with your extended family. This creates familiarity. If you like your job, you may also like your company. Some of you reading this may absolutely love your company's politics, product and prospects. This compounds your familiarity, but won't necessarily compound your return.
There's also another incentive to owning the stock of the company by whom you are employed: the Employee Stock Purchase Program. This is an opportunity for the employee to purchase the stock at a 10 to 15% discount to the price available in the market. This discount added to familiarity with the company stock that you work for can be too irresistible for some investors. However, there's a couple caveats. First, in an employer's 401k, company stock can be subject to Net Unrealized Appreciation at the time of distribution. Second, stock held in an Employee Stock Purchase Program may have a mandatory hold time, irrespective of stock performance or your personal time horizon.
The flip side of familiarity bias is when an investor shuns what he is not familiar with. For instance, in an effort to diversify a financial planner may create an asset allocation recommendation that includes emerging market debt. The conversation that follows goes a something like this:
Client, "What's an emerging market?"
The financial planner explains the parameters of an emerging market, much to the client's chagrin.
Client, "I've never even heard of some of those countries. And isn't being in debt a bad thing? Why are we investing in debt?"
The financial planner explains that the fixed income portion of their portfolio is the debt obligations of governments and corporations. The client is making a loan when they purchase debt or fixed income.
The client crosses his arms and frowns. This is all so unfamiliar, it must be bad.
Think about your plate at your favorite restaurant. You learned as a child you can't have just a plate of desert. Over time you've learned that you have a balanced diet that includes a little desert, protein, fat, starch, vegetables and so on. The analogy for investing is the same. In fact, your plate (asset allocation) should include things that you are unfamiliar with.
This is not a categoric shaming of investors who own individual stock. I could illustrate the familiarity bias using investments like mutual funds, real estate or gold. The investment vehicle isn't the point. Nor is this an extensive list of the potential pitfalls of a familiarity-based portfolio.
Keep in mind that the familiarity bias is only one of many biases that beset the investor. The problem with biases is that they are the lenses through which we see a situation. You can't see your lenses, you see through them. The key takeaway is that it helps to have a fresh set of eyes to look at your portfolio. A fiduciary who stands in a special relationship of trust, confidence, and legal responsibility can be those fresh set of eyes. If you'd like a fresh set of eyes, click here.