There are estimates that five million Americans have more than 60 percent of their retirement savings in company stock, over 2 million Americans hold 40–60 percent of their retirement savings in company stock, and more than 3 million Americans hold 20–40 percent of their retirement savings in company stock.2
Certainly, investors hear alarming investment nightmare stories about people who held a large proportion of their personal wealth in their employer's stock and lost everything.3 4 While your client may think, "I know this company because I work here," that thinking can get them into trouble — think WorldCom and Lehman Brothers. These two firms, in particular, encouraged employees to hold company stock inside and outside of their retirement accounts. Beyond the risks of having a large a mount of one's portfolio in a single stock, holding a high amount of employer stock means both their "day job" and their financial fortunes are tied to only one company. If something happens to the firm, your clients could lose their jobs and a large percentage of their financial wealth at the same time. That is a very risky investment strategy.
Familiarity bias is the tendency for individuals to be more comfortable with what's familiar, dislike ambiguity, and look for ways to avoid the unknown.
So why do investors continue to do just that, despite the horror stories we hear when a firm like Lehman Brothers gets into trouble? The short answer is something called familiarity bias. Familiarity bias is the tendency for individuals to be more comfortable with what's familiar, dislike ambiguity, and look for ways to avoid the unknown. There are several types of familiarity biases, some of which can influence your clients' investment preferences and some of which can affect you and how you may manage your clients' portfolios. Every financial advisor understands the need for, and benefits of, portfolio diversification. Familiarity biases can have a significant negative effect on portfolio diversification.
Despite the risks, employees often invest a significant portion of wealth in employer stock because their employer is a company that is very familiar to them. There is a belief that working at a company gives them certain informational advantages. However, that company perspective generally does not translate into higher portfolio returns, nor does it compensate for the risk of limited diversification. This type of familiarity bias also can be manifested as a general "local" investing bias. You probably have clients who prefer to invest in the stock of companies that are in their local area or state. Again, they are favoring local market companies because they feel that they have informational advantages about them, as they're more familiar with them — when that is not necessarily the case (Huberman, 2001).
Familiarity Biases and Advisors
Unfortunately, clients are not the only ones who can be influenced by familiarity biases. As advisors, various types of familiarity biases can affect you, too. Researchers Coval & Moskowitz (1999) show that U.S. investment managers also have a strong preference for locally headquartered firms. Additionally, home bias can influence advisors. Home bias is the propensity to favor domestic financial investments over international ones. While there is a rich academic literature that documents the benefits of international diversification (e.g., DeSantis & Gerard, 1997), home bias is very persistent ( Ahearne et al., 2004; French & Poterba, 1991). This bias strongly influences portfolio manager investment decisions, even when greater diversification outside of domestic markets might yield greater return and lessen risk.
The reason these biases cause problems is that they limit portfolio diversification. While certain familiarity biases are more likely to affect your clients' investment preferences, other familiarity biases can influence you as an advisor. Some familiarity biases cause clients to invest too heavily in a particular security, while other types of familiarity biases can cause investors to avoid certain types of securities. Your job is to be aware of these influences when trying to diversify a client's portfolio appropriately.
- There are several types of familiarity biases – some that are more likely to affect your client and some that can also influence you, the advisor.
- While certain familiarity biases can cause clients to invest too heavily in a particular security, other types of familiarity biases can cause investors to avoid certain securities.
- Familiarity biases can be an enemy to portfolio diversification.
- Be aware that these influences exist, and do not let them interfere with the appropriate diversification strategies for your client portfolios.
2Mitchell, Olivia S. and Utkus, Stephen P. (2003). "The Role of Company Stock in Defined Contribution Plans." in The Pension Challenge: Risk Transfers and Retirement Income Security. Mitchell, Olivia S. and Kent Smetters (eds.) Oxford, UK: Oxford University Press.
3Woolley, Suzanne. (October 13, 2016). "Wells Fargo Is Your Last Warning: Check Your 401(k)" Bloomberg.com
4Lieber, Ron. (March 20, 2015). "A Scary Movie: Filling Your 401(k) with Company Stock" nytimes.com
Ahearne, Alan, William Grieve, and Francis Warnock. (2004). "Information Costs and Home Bias: An Analysis of U.S. Holding of Foreign Equities." Journal of International Economics 62, 313–336.
Coval, Joshua D. and Tobias J. Moskowitz. (1999). "Home Bias at Home: Local Equity Preference in Domestic Portfolios." Journal of Finance 54 (6), 2045-2073.
De Santis, Giorgio, and Bruno Gerard. (1997). "International Asset Pricing and Portfolio Diversification with Time-Varying Risk." Journal of Finance 52, 1881–1912.
French, Kenneth, and James Poterba. (1991). "International Diversification and International Equity Markets." American Economic Review 81, 222–226.
Huberman, G. (2001). "Familiarity Breeds Investment." Review of Financial Studies 14 (3), 659 - 680.
Diversification does not ensure a profit protect against a loss in a declining market.
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