Do you ever find that whenever you go to your favourite restarant, you always end up ordering your favourite dish? It’s no secret that people like to stick with what they know – it’s a useful time saving shortcut that we use in our everyday lives because we know for sure that the result is going to predictably be the one we’re looking for.
This is a well documented psychological bias called the Mere Exposure or Familiarity Effect, and it is an unconscious human behaviour which deeply influences our decision-making. This term, coined by Zajonc in 1968, refers to the fact that people become more positive to things that they are exposed to more often – because it becomes a familiar sight.
An interesting study which investigated this bias was entitled “Reversed Facial Images and the Mere-Exposure Hypothesis” (Mita, Dermer and Knight, 1977) and could be applied to everyday life. In this study, the investigators reasoned that people would be more positively inclined to mirror images of themselves than actual pictures, as this was the view of their own face that they were exposed to on a frequent basis. Alternatively, the researchers hypothesized that friends of the participants would be more positive to actual pictures of the participants rather than the mirror image – because this was what they were exposed to most frequently. The researchers performed an experiment with 37 participants and found that this was indeed in the case – participants much preferred mirror images of themselves, while their friends were the opposite. So next time a friend asks you to delete all the pictures you’ve just taken of them, just laugh all knowingly and point them towards this study.
So, this is all good when you’re debating the finer points of selfie aesthetics with the missus, but does it apply for finance? You bet it does. Kang and Stulz (1995) noted that even though investors had the choice of investing in the international market, they tended to stick for the stocks of their home country – even if it defied logic. Another study by Mitchell and Utkus (2002) found that employees tended to invest a high proportion of their pension funds in their own employer’s shares – a risky endeavour which is a big no-no when it comes to portfolio diversification.
So it happens, so what? Well, it can have a negative effect on your portfolio. An investigation by Bhamra and Uppal (2015) found that when investors flock towards stock that they are familiar with, this can increase the risk of the overall portfolio – which can then lead to a heightened demand for risk free assets and this in turn affects prices and yields. So it’s not something you want to do with your portfolio, because you’re focusing all your funds in one area and when this area falls in value, your whole portfolio falls in value.
What can you do to avoid this bias? The answer is simple: Diversify, diversify, diversify! Always be mindful of what you’re investing in – make sure you’re not putting all of your faith in a single company’s stock or disregarding the entire international market in favour of your home team. You need to stay aware of the risk that you’re willing to take on and actively think about spreading your portfolio, and this way you can avoid any pitfalls when a company or sector fails to perform.