Familiarity Bias: Why “Homegrown” Investments Can Hurt Diversification

Investors often struggle to achieve optimal portfolio diversification, and one significant culprit is familiarity bias. This bias, deeply rooted in human psychology, leads individuals to favor investments they are familiar with, understand, or feel connected to, often at the expense of broader diversification. Essentially, familiarity bias makes us gravitate towards the “known” and shy away from the “unknown” in the investment world, even when the unknown might offer better opportunities or reduced risk through diversification.

This preference for the familiar manifests in several ways. Investors might overweight their portfolios with stocks of companies based in their home country, state, or even local area. They may favor companies whose products or services they use regularly or brands they recognize from daily life. Another common example is investing heavily in their employer’s stock. While these investments might feel comfortable and understandable, they often lead to portfolios that are heavily concentrated and lack the benefits of true diversification.

The core issue is that familiarity often equates to a perceived sense of safety and understanding, not actual safety or superior returns. We tend to believe we have an edge in evaluating companies or industries we are familiar with. If you work in the tech industry, for instance, you might feel you have a better grasp of tech companies and their prospects, leading you to overinvest in tech stocks. Similarly, if you live in a region known for a specific industry, like oil and gas, you might feel more confident investing in companies in that sector. This feeling of control and understanding, however, can be illusory and lead to poor investment decisions.

Why does this bias hinder diversification? True diversification aims to spread risk across different asset classes, sectors, geographies, and investment styles. By overemphasizing familiar investments, investors inadvertently concentrate their portfolios. For example, if an investor primarily invests in domestic stocks because they are more “familiar” than international markets, they miss out on potential growth opportunities in other economies and expose themselves to the specific risks of their home market. If their home country’s economy falters, their entire portfolio could suffer disproportionately.

Similarly, investing heavily in your employer’s stock, a classic example of familiarity bias, creates significant concentration risk. Your financial well-being becomes overly reliant on the performance of a single company. If the company faces difficulties, you risk losing both your job and a significant portion of your investment portfolio simultaneously – a double whammy that diversification is designed to prevent.

Overcoming familiarity bias requires conscious effort and a shift in perspective. Investors need to recognize that feeling comfortable with an investment doesn’t automatically make it a good investment or a strategically sound portfolio component. Instead, focus should be placed on building a portfolio based on well-defined financial goals, risk tolerance, and a diversified asset allocation strategy. This often means venturing beyond the familiar and exploring investments in different sectors, industries, and global markets, even if they initially feel less comfortable or less well-understood. Seeking advice from a qualified financial advisor can also be invaluable in identifying and mitigating familiarity bias, helping investors build truly diversified portfolios that are better positioned to achieve their long-term financial objectives.