The Familiar Can Become Dangerous

Familiarity bias

Our next personal finance bias is a behavior that is very subtle and insidious. Familiarity bias causes investors to underestimate the risks associated with investing in the securities of an organization that is well known to them. This is very prevalent with employer stock in 401k retirement plans.  

The typical 401k plan offers its participants a menu of potential investments. Generally, the choices include various pooled investment vehicles such as mutual funds and/or collective investment trusts. One of the under-appreciated benefits of such investments is diversification. Most (but not all) mutual funds are classified as “diversified” by the Securities and Exchange Commission because they hold many different investment securities. One of the requirements is the necessity for the mutual fund to refrain from investing more than 5% of its assets in the same security. The net effect of this rule is that the risk of negative performance by one individual holding will have greatly reduced consequences for the portfolio as a whole. Numerous academic studies have validated the fact that each and every individual security involves greater financial risk than a broadly diversified portfolio. 

Many 401k plans allow participants to invest in the common stock of the employer company. Familiarity bias causes some participants to over allocate (in some cases to 100%) their account into the company stock. This is due to the mistaken notion that this is somehow less risky because, “I work there and know a great deal about the organization.” Some participants may even believe that owning a great deal of company stock indicates that they are a good and loyal employee.  

Nothing could be further from the truth. Even blue-chip companies like Apple, Coca Cola and Johnson & Johnson experience common stock volatility that is far greater than a broadly diversified portfolio. Unfortunately, financial history is replete with stories of 401k participants’ experiencing severe losses because they fell victim to familiarity bias.

Familiarity bias also manifests itself when U.S. based investors avoid consideration of foreign markets and limit investments to domestic companies. It is important to note that more than 50% of the investible universe lies outside the borders of the United States. By limiting investments to U.S. companies only, good opportunities for diversification and financial return are forsaken.

If you would like to learn more about these and other wise financial planning moves, please contact us through our Level 5 Financial LLC website or via phone at 719-323-1240.  This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice.  You should consult your own tax, legal and accounting advisors before engaging in any transaction.

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