Ah…how we all love familiarity. The comfort. That at home feeling. The perceived safety that comes with preconceived knowledge. Familiarity bias in stock investing is no different.
What is familiarity bias?
Familiarity bias is when we feel that an investment is good, or even worthwhile, because we are familiar with it.
We feel that we have some “insider” knowledge of a product, industry, field, technology, you name it. So, we believe that we can leverage this familiarity and perceived knowledge to invest and outperform the market.
This plays out allllll the time, especially in stock investing. Someone works in product development and thinks some new technology will push some product into the stratosphere. So they buy some stock in the company with the technology and/or product.
As physicians, we are particularly susceptible to this bias
Why?
Well…
- We are in a field, medicine, that is constantly innovating
- Doctors are know-it-alls
- We all think we know what is the next big thing
- Our job involves preparing for and predicting the future
- Our field is sexy to investors and often the subject of massive speculation
If I had a dollar for every doctor that has told me they like to invest in medical technology because they really feel it is going to take off…Oh yeah, and because they feel they can understand it, I could shave a few years off of my retirement.
That’s exactly the problem with familiarity bias. It lulls us into a false sense of security. All of a sudden, we think we can beat the stock market and time the market and do all these sorts of things that we just can’t.
Familiarity bias plays into the worst aspects of investing
The value of a stock is based really on three components:
1. The dividends that the stock pays out
2. The Price-to-Earning (P/E) ratio
Yes, I know I mentioned only 2 of the 3 components so far. But I want to start with them as they are the most important.
When you buy a stock and it pays you a lot of dividends or its price goes up, that is good for you. It means that your stock is now making you more money.
Now, it’s important to note that P/E ratios can sometimes get really out of whack with a company’s stock price having little to do with its actual earnings (see the recent Gamestop/Reddit debacle).
And this leads us to the third component of a stock’s value:
3. Speculation
There is obviously a big speculative component to a stock’s value. That’s exactly what happened with the Gamestop stock. Its stock price was artificially elevated way beyond the company’s actual earnings. This was an extreme example but it happens with all stocks, both in the negative as well as the positive direction.
When you are investing in stocks, you should focus on the first two components while, in my opinion, ignoring the third
That is what you are doing when you invest in broadly diversified, low cost index funds, like me.
It’s what you are doing when you set an asset allocation based on your risk tolerance and rebalance once yearly.
It is NOT what you are doing when you stock pick or try to time the market.
And familiarity bias is exactly the type of influence that makes people think that they can stock pick or time the market.
And this gets people into trouble.
Make sure you are investing, not speculating
When you invest, you are minimizing risk and maximizing return.
The only way to do this in the stock market is through index fund investing and approximately the market. In doing this, I pin my hopes and money on the entire US and world economy. If something good happens for me and my money, it’s happening for everyone.
When you speculate, you are hoping and banking on something happening that is good for you and inherently bad for others. Right?
You are making a bet, and someone has to win and someone has to lose.
Even if you are making a small bet, like on medical technology stocks because you are a doctor and know the field, you are still speculating.
Think about your investments right now and see if you are relying, even a little, bit on the speculative component on the stock market’s value.
If so, I would strongly consider adjusting to minimize your risk and maximize your reward.
Remember, you are a physician or high-income earner. You don’t need crazy risky investment strategies to grow wealth and achieve financial freedom.
There is a simple tried-and-true formula for you to follow!
The 7 Steps Basic Formula for Wealth as a Physician
What do you think? Do you invest in stocks that you are familiar with? Do you think this gives you an advantage? What other biases are we susceptible to as investors? Let me know in the comments below!
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Yeah dude well said. I think Peter Lynch killed it for a lot of us when he said invest in what you know. Technically you really have to look at what it means to “know” a company and it’s stock. Peter Lynch and Warren Buffet are the only dudes I know that really “know” the companies they invested in.
This is a great post! What people know isn’t necessarily unique, it could already be priced into the market. It might be not be an edge. I wonder in fact if consumer discretionary stocks have lower returns for this reason.
I prefer to just buy Vanguard total stock market and chill.