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Fear of the Unknown: Familiarity, Risk and Economic Decisions

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Rotman Professor Bing Han discusses our fear of the unknown in capital markets.

MOST OF US RECOGNIZE THAT, generally speaking, people fear change and the unknown. We prefer familiar goods and people, status quo choices, and gambles that seem unambiguous. What some people might not realize is that these effects are not only manifested in the realm of consumer goods, but
also in capital markets.

My co-authors and I recently set out to develop a model based upon two underlying psychological forces:

  1. The tendency for individuals to use a ‘focal choice’ as a benchmark for comparison in evaluating other possible choices. We refer to this focal choice option as the status quo; and
  2. The tendency to skeptically evaluate choice alternatives that deviate from the status quo.

An individual who is subject to the status quo bias prefers either the current state or some choice alternative that has been made salient as the default option that will apply if no alternative is selected explicitly. For example, in a set of experiments on portfolio choices following a hypothetical inheritance, researchers found that an option becomes significantly more popular when it is designated as the status quo, while others are designated as ‘alternatives’.

When neither choice alternative is made salient as a passive default choice, sometimes, the focal choice becomes the one that is easiest to process. The greater comfort that individuals have with easily-processed choice alternatives probably lies in the fact that we prefer choices about which we can feel competent.

Another principle that has emerged from the research is that when there is a single clear-cut focal choice alternative, people evaluate choice alternatives that deviate from the focal choice with skepticism. For example, people tend to dislike risks that derive from active choices more than risks that result from remaining passive. Psychologists have referred to this as the omission bias, and it explains why individuals are reluctant to take seemingly risky actions such as getting vaccinated, often preferring to bear the much bigger risks associated with remaining passive.


Investors have a greater ‘perceived familiarity’ with local and domestic securities and, in turn, invest more in them.Tweet this


More broadly, psychologists have documented a strong and robust mere exposure effect: individuals tend to like stimuli that are more familiar. Advertisers try to take advantage of this by repeatedly exposing consumers to the name of a brand, hoping that consumers will use it as a default choice when they face many similar products.

In general, things that we are familiar with, choice alternatives that fall within our domain of competence, and default choice alternatives that involve continuing to do what we were doing previously, will tend to be viewed as ‘less risky’ than new initiatives into unknown territory. As a result, it makes sense as a general heuristic to favour familiar or status quo choice alternatives. Such a heuristic can go astray, however, when in fact we possess other clear sources of information about the distributions of payoffs of different alternatives.

There is a great deal of evidence suggesting that these two psychological forces—the tendency to evaluate choices relative to a focal-choice benchmark, and the tendency to be unduly skeptical about non-focal choice alternatives—operate robustly in capital market decisions. 

In corporate finance, a manager’s reluctance to terminate an investment, involves holding insistently to a previously-selected or endowed choice alternative. Previous studies document that firms commonly use hurdle rates that exceed the cost of capital, thereby discouraging new projects. A related phenomenon is the sunk-cost effect, whereby an initial investment in a project creates reluctance to terminate it.

In the realm of stock investments, individuals have also been shown to prefer familiar choices. For example, U.S. investment managers invest disproportionately in locally headquartered firms. Researchers have found that customers of a given U.S. Regional Bell Operating Company (RBOC) tend to hold more of its shares and invest more money in it than in other RBOCs; that both institutional and individual investors in Finland tend to hold the shares of firms that have nearby headquarters and communicate in investors’ native tongue; and that Swedish investors tend to concentrate holdings in stocks to which the investor is geographically close.


We introduced the concept of Status Quo Deviation Aversion (SQDA), which gives a privileged position to the status quo strategy.Tweet this


Research also shows that investors have a greater ‘perceived familiarity’ with local and domestic securities and, in turn, invest more in such securities. In pension fund investments, many people invest a significant fraction of their discretionary contributions in their own company stock. For example, researchers found that the percentage of assets in company stock in defined-contribution plans is around 29 per cent; and another study of sample S&P 500 firms found that about one third of the assets in retirement plans are invested in company stock, and of the ‘discretionary contributions’, about a quarter are invested in company stock.

Furthermore, in international financial markets, investors tend to hold domestic assets instead of diversifying across countries, a puzzle known as home bias. Although various explanations—such as transaction costs, differential taxes, political risk, exchange rate risk, asymmetric information, purchasing power parity, and non-tradable assets—have been offered, none has been shown to explain the magnitude of observed home bias.

In my research with H. Henry Cao, David Hirshleifer and Harold Zhang, we introduced the concept of Status Quo Deviation Aversion (SQDA), which gives a privileged position to the status quo strategy. We found that a strategy is preferred to the status quo strategy only if it provides higher expected utility under all probability models that capture the investment uncertainty. When there are other choices that dominate the status quo option, the investor evaluates each strategy under the scenario that is most adverse to that strategy. Thus, if the status quo action is dominated by an alternative strategy x, then strategy x is evaluated according to the minimum gains in expected utility, and the alternative strategy with the highest minimum gains in expected utility is selected.

In our model, fear of the unfamiliar derives from aversion to model uncertainty about the mean payoffs of unfamiliar choice alternatives. We then examined the implications of familiarity bias for individuals’ decision making, demonstrating that this bias can induce the endowment effect (whereby people ascribe more value to things merely because they own them) and under-diversification in risky asset holdings. Put simply, investors who exhibit familiarity bias focus on the worst-case scenarios associated with contemplated deviations from status quo choices.

Spring2017-IdeaExchange-BingHanPhoto

Our interpretation of familiarity bias can explain the use by managers of excessively-high hurdle rates in certain investment choices, and also in the reluctance to terminate existing investments. Unlike the rational investor’s ‘optimal risky portfolio’, which is determined by the expected returns of stocks and their co-variances, the familiarity-biased investor’s equity portfolio also depends on his endowment and the degree of uncertainty about expected stock returns. Even when the familiarity-biased investor trades away from his endowment in the direction of the stock having superior risk-return trade-off, he is more conservative than the rational investor, as he under-weighs the more attractive stock.

Our finding that limited diversification can occur due to fear of unfamiliar choice options suggests that mutual funds (and especially index funds) can provide a social benefit for a reason different from standard explanations. In our model, investors stop adding stocks to their portfolios because a large diversification gain is needed to offset the aversion to buying an unfamiliar stock. A mutual fund can address this issue in two ways. First, the individual needs to add just a single new asset to his portfolio (the mutual fund); and second, by focusing on marketing to investors, mutual funds can make their product more familiar to them. In other words, whereas corporations specialize in making profits, mutual funds can specialize in being invested in.

Our approach suggests that there is a socially-valuable complementarity between being good at marketing that assuages investor fears about stocks, and providing a diversified portfolio of securities in which individuals can invest.

In closing

The evidence indicates that individuals favour geographically-and linguistically-proximate and more familiar investments; that they are biased in favour of staying at current consumption/investment positions or strategies and in favour of choice alternatives made salient as default options; and that they are averse even to small gambles when presented as increments relative to an endowed certainty position. More generally, individuals are more reluctant to take actions that impose risk than to bear risk associated with remaining passive; tend to like stimuli they have already been exposed to; and tend to like people they are located close to.

As indicated herein, emotions of fear and suspicion are often directed towards the unfamiliar, and this phenomenon explains several biases in individual psychology as well as in economic and financial decisions.


Bing Han is a Professor of Finance at the Rotman School of Management. This article summarizes his paper, “Fear of the Unknown: Familiarity and Economic Decisions”, co-authored with H. Henry Cao, David Hirshleifer and Harold Zhang. The complete paper, published by the Review of Finance, can be downloaded online.

Rotman faculty research is ranked #3 globally by the Financial Times.


This article originally appeared in The Behavioural Issue (Spring 2017) of Rotman Management magazine.

 


 

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