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Fear of the Unknown: Familiarity and Economic Decisions

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Fear of the Unknown: Familiarity and Economic Decisions

1. Introduction
The paper by H. Henry Cao, Bing Han, David Hirshleifer and Harold H. Zhang discuss how individuals favor familiar, geographically and linguistically close investments. The authors believe that investors are reluctant about trading away from their present ownership positions; are influenced by benchmark choices (i.e. status quo); and retain their past investment choices. For an individual, any choice that deviates from the status quo choice is likely to go against his interests thereby creating familiarity bias. In addition, pessimistic beliefs cause fear of the unfamiliar or change i.e. familiarity bias. An individual chooses a strategy devoid of status quo only if the strategy offers higher expected value than any other model across the world. Domestic investors are uncertain about foreign assets than about domestic assets, thereby leading them to favor domestic assets and form a home bias. In addition, when familiarity bias and uncertainty are high, investors choose not to trade. 
2.    Motivating Evidence
   The authors summarize the evidence associated to human attitudes towards familiarity and straying from the status quo choices. Individuals dislike active risks and choose to bear bigger risks by remaining passive. People often demand a higher price to give up an object and would go on to pay higher price to acquire it. This difference between the willingness to pay and the willingness to accept is called the endowment effect. The authors deem that individuals prefer familiar investments while in international financial markets individuals choose to hold domestic assets.
3.    The Model
      The model reflects the fear of change and uncertainty of investors and how they choose to   deviate from the status quo only if the other strategy offers maximum gains in the expected utility.    
4.    The Endowment Effect
4.1 The Basic Model
The authors examine the endowment effect produced by preference to familiarity.  
4.2 Aversion to Bad Cases Instead of Worst Cases
The authors believe that investors concentrate on bad cases instead of worst cases.
4.3 The No-Trade Condition under Familiarity Bias
The authors select the portfolio choice with one risky stock and another risk-free stock and provide conditions where no trade is said to be most favorable for the investor.  
5. Calibration Analysis of the Home Bias Puzzle
Investors usually tend to retain assets of the country they reside in, instead of opting for international diversification. The authors analyze familiarity bias to decide how much uncertainty is required to retain local assets.  
6. Underdiversification
The authors demonstrate how the investors, in the process of deviating from the status quo options, become underdiversified and do not observe further diversification to be favorable. In this scenario, mutual funds become beneficial. 
7. Capital Market Equilibrium with Familiarity Bias
The authors investigate how familiarity influences trading and prices as part of capital market equilibrium. They consider four investor groups of domestic and foreign rational investors, and domestic and foreign investors who are subject to familiarity bias.
8. Conclusion
The authors conclude that individuals favor geographically, linguistically close, familiar and domestic investments. Fear of change and of the unfamiliar create familiarity, local, home and status quo biases.

Cao, H. Henry, Han, Bing, Hirshleifer, David A. and Zhang, Harold H., "Fear of the Unknown: Familiarity and Economic Decisions" (April 2007). Available at SSRN: http://ssrn.com/abstract=985381

 

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