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2-1.3. Familiarity Bias and Background Risk

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Investments II: Lessons and Applications for Investors

University of Illinois at Urbana-Champaign

4.8 (384 ratings) | 8.8K Students Enrolled

Course 4 of 7 in the Financial Management Specialization

In this course, you will start by reviewing the fundamentals of investments, including the trading off of return and risk when forming a portfolio, asset pricing models such as the Capital Asset Pricing Model (CAPM) and the 3-Factor Model, and the efficient market hypothesis. You will be introduced to the two components of stock returns – dividends and capital gains – and will learn how each are taxed and the incentives provided to investors from a realization-based capital gains tax. You will examine the investment decisions (and behavioral biases) of participants in defined-contribution (DC) pension plans like 401(k) plans in the U.S. and will learn about the evidence regarding the performance of individual investors in their stock portfolios. The course concludes by discussing the evidence regarding the performance of actively-managed mutual funds. You will learn about the fees charged to investors by mutual funds and the evidence regarding the relation between fees charged and fund performance. Segments of the portfolios of mutual funds that may be more likely to outperform and examples of strategies designed to “earn alpha” will also be introduced. Learners are welcome to take this course even if they have not completed "Investments I: Fundamentals of Performance Evaluation," as the first module contain a review of investment fundamentals and regression analysis to get everyone up to speed. Also, the course contains several innovative features, including creative out-of-the-studio introductions followed by quick-hitting "Module in 60" countdowns that highlight what will be covered in each module, four "Faculty Focus" interview episodes with leading professors in finance, and a summary of each module done with the help of animations! This course is part of the iMBA offered by the University of Illinois, a flexible, fully-accredited online MBA at an incredibly competitive price. For more information, please see the Resource page in this course and onlinemba.illinois.edu.

Skills You'll Learn

Stock, Financial Markets, Investment Strategy, Investment

Reviews

4.8 (384 ratings)

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KL

Dec 07, 2017

Professor Weisbenner is amazing! Insanely smart, yet delvers complex concepts in such a manner you would never realize it. This is a must take class for investments!

DH

Mar 12, 2018

Professor Weisbenner is phenomenal! The course material is accessible, very well presented, highly informative, and can be applied for the rest of your life.

From the lesson

Module 2: Investment Decisions in DC Pension Plans

In Module 2, we discuss the investment decisions of participants in defined-contribution (DC) pension plans like 401(k) plans in the U.S. Not falling prey to common behavioral biases is key to sound financial decision-making in these retirement plans, so we will discuss common behavioral biases of DC pension plan participants.

2-1.1. Overview of Key Biases in Decisions9:32

2-1.2. Representativeness4:29

2-1.3. Familiarity Bias and Background Risk22:22

2-1.4. Endorsement Effects7:27

2-1.5. Naïve Diversification18:47

2-1.6. Inertia4:58

2-1.7. Option Confusion5:36

2-1.8. Power of Defaults16:19

2-1.9. Bottom Line on Biases in Investment Decisions7:53

Taught By

Scott Weisbenner
William G. Karnes Professor of Finance

Transcript

[MUSIC]

So we're continuing with our countdown of behavioral biases in DC pension plan

investing.

And now we're going to talk about familiarity bias.

And I would say, this is a key one just to be aware of and

to think about when you're constructing your own portfolio.

If I had to look at all of these, this is probably one to kind of really highlight.

So what do we mean when we're talking about familiarity bias?

Well, familiarity in investments is just simply misinterpreting casual knowledge

of an investment or firm as that investment or firm being less risky.

I drive by this company every day.

I know some percentage of companies will fail, but this one won't fail because it's

right in my backyard, or it's a company I happen to work for.

Now this could potentially explain a lot of investment in company stock,

people investing in their own firm's stock.

If they underestimate its risk because they simply are familiar with it, so

therefore, they view it as less risky, less likely to fail, okay?

So this is kind of consistent with,

I invest in my own firm's stock because I think it's less risky.

So that's kind of like, your doing a risk return calculation but

the problem is you're mismeasuring the risk, okay?

So here are some examples of familiarity bias.

Here, the guy, with this jaguar here, like hey, I know the jaguar seems

like it's calm now, but is it really such a good idea to have your neck four inches

from his from his mouth here, that might be the indication of familiarity bias.

And then I love this picture here of kind of the ostrich pulling the carriage here.

Is it really a good idea to have that back foot being able to kick you and

basically give you a concussion or

knock you out cold here when you're driving the carriage here.

So we see familiarity bias here with animals.

The question is, do we also see this in the realm of investment?

And that provides a great segue to thinking about this concept

of background risk, okay?

So when you're making financial choices,

you need to consider your total portfolio of assets and liability.

So let's get some examples.

So you insure property, and in particular, you insure homes in Miami.

It's probably not a good idea for you also then to invest in Miami real estate, why?

If there's a hurricane that comes through Miami, you're going to own a lot of

insurance claims, plus your own asset base will fall at the same time, okay?

A state pension fund probably shouldn't invest a lot of within-state stocks,

okay, why?

If the local economy is doing poorly, the assets of the pension fund will fall

at the same time state tax revenue is falling.

On the flip side, if the economy is doing well, state tax revenues coming in, and

then your assets are going up.

So when you're doing these strategies here, they're setting you up for

extreme win-win or lose-lose scenarios.

We discussed it in my first course on investment,

this Public Benefit Guaranty Corporation, or PBGC,

that's an insurer of company defined-benefit plans.

So if a company goes bankrupt, the PBGC

will take over the defined-benefit pension obligations to the workers.

So how should this entity invest?

Investing a lot in the stock market for

the PBGC probably isn't a great idea because of the background risk, right?

If the firms are doing poorly, some of them will be going bankrupt.

The PBGC will have to payout more claims on their defined-benefit plans.

And if the PBGC at the same time is investing in the stock market,

the stock market will be falling, so

their liabilities will be going up at the same time their assets are going down.

So now let's do, Le Penseur is back, we know what that means, pause,

think, and answer.

Kind of an all time classic segment on the course.

So a few questions to think about.

Should you invest heavily in the stock of your employer?

What are the pros and cons of doing so?

What would investment theory say is the optimal level of investment

in your own firm's stock?

So let's think about these three questions.

You may already have made a decision on this and it's reflected in your portfolio,

so it's good to think about this.

Is this a decision that makes sense or not?

What are the pros and cons of investing in your own firm's stock?

All right, so let's think about these questions.

I think very relevant questions that we all may have to think about particularly

if we work for

a publicly traded firm where it's easy to buy stock of our company.

And it may even be an investment option in our retirement plan here.

Should we invest heavily in the stock of our employer?

What are the pros and cons?

What would investment theory say is the optimal level of investment in your own

firm's stock?

Well, let's kind of take the last one first.

Finance 101, we want to have a diversified portfolio,

that would suggest we don't want to overweight one company.

Particularly a company where our human capital is tied to that firm, okay?

So the Finance 101 answer would be like a small amount investment

in company stock or maybe we actually want to hedge our company stock

exposure because our human capital is tied very much to how the firm is doing.

What are the pros and cons?

The cons are, if you invest a lot in your own firm's stock,

you're setting yourself up for either win-win, lose-lose scenarios.

If the firm happens to be Microsoft or Google, great.

But what if the firm happens to be Enron or United Airlines,

going through bankruptcy, then not so great.

So Finance 101 would suggest to invest basically zero or little in company stock.

Keeping up with the Jones' behavioral effect might suggest like, hey, maybe you

want to invest a little bit maybe 5 or 10% of your portfolio in company stock.

At the end of the day, that won't kind of matter that much.

But if your company happens to the next Microsoft or Google,

at least you'll get some of this upside potential.

And you won't be the only one in the office, let's say,

that doesn't get to participate in the upside of your company.

But the key thing is just be aware, if you invest a lot, you're setting yourself

up for a win-win or potentially very devastating lose-lose scenario.

So doubling down on background risk, you invest a lot of your financial

portfolio in a company that your human capital and future wages are tied to.

It can set you up for

either this you become kind of like the Monopoly man, super wealthy.

Or you're basically the exact opposite, and kind of so much for retirement.

Now, if you're risk adverse, we're assuming you don't want to kind of take

the risk of having this downside lose-lose possibility.

So therefore, you take a middle-of-the-road strategy.

But when you are doubling down on background risk,

investing in the stock of the company where you work,

you're really setting yourself up for one of these two possibilities here, okay?

So let's look into familiarity bias, is it really there when we interview people?

John Hancock Financial Services conducted several Defined Contribution Plan Surveys

of DC planned participants in the 1990s and 2000s.

Two questions they asked in particular help explain why we see

many DC plan participants investing in company stock, okay?

So one of the questions where participants were asked

to rate how familiar they are with various investment options on a scale of one,

I don't know anything about it.

To five very familiar.

That's a direct familiarity question.

How familiar are you with these options?

Then the second question was, participants asked to rate the risk associated with

various investment options on a scale of 1, no risk to 5, high risk.

Naturally we can look at the responses of these two questions and

see if there's any correlation.

Investment options that people say, hey I'm familiar with it, I know it.

Do they also say, hey I don't view that as very risky.

Now let's look at the results of the John Hancock survey.

We have various Investment Options here.

Okay, which of those are kind of viewed by participants as and

options that they're most familiar with?

Interesting is the comparison of Company Stock versus the International Stock Fund.

Company Stock actually scores the highest,

people can answer from one to 0 to 4 here.

1 to 5.

The average response for company stock is 3.5.

That's the highest across all the Investment Options.

People are more familiar with their own Company's Stock

than any of these other Investment Options.

That seems to kind of make sense.

People are least familiar with International Stock Fund.

Again, these are, you could answer from 1 to 5.

5 as, you're very familiar with, the 1 not at all.

Remember that pattern.

Company Stock most familiar,

International Stock Fund people are least familiar with it.

Now let's look at this,

what do you view as a Perceived Risk of the Investment Options.

Again, this is people could answer from 1 to 5.

Look at the differences here.

Your own stock, the stock of one company is viewed

much less risky than this International Stock Fund.

And also less risky than the market as a whole.

Think about this.

And this is a very robust result that we've seen in

multiple John Hancock surveys of DC plan participants.

They always view Company Stock as a very familiar Investment Option.

And they actually will assess the risk one company is less than the risk

of the overall market, and a lot less in the risk of kind of International Stocks.

What does that mean?

kind of summarizing these results, own-company stock consistently

rated as an investment option With which participants are the most familiar.

Very surprisingly, participants will consistently rate own-company stock

as less risky than both general international stock fund,

as well as a US stock fund, and about having the same risk,

your own firm has about the same risk, as a life style fund or a balance fund.

Finance 101 would say, hey I don't think that kind of makes sense but

that's the way people seem to view it and

that probably reflects this gigantic familiarity bias.

I work at this company therefore it's safe.

I know other individual companies are risky but

my company is not like those other companies.

The good news is, the investment in company stock,

we see a lot of it by DC plan participants,

could reflect kind of a naive reward-risk tradeoff being made.

Kind of a basic finance calculation.

Now the bad news is, the risk in this reward-risk tradeoff, is substantially

underestimated for company stock because of the familiarity bias.

When you're making your financial choices,

take into account your total portfolio of assets.

Don't just narrowly focus on your financial assets,

think of your total portfolio of assets.

You have assets in different retirement plans, assets in taxable and

tax deferred accounts, real estate is a big asset and your human capital.

By human capital the future salary you'll get from your job.

Taken to account your overall portfolio when your making financial choices and

the correlations across these assets.

In particular, you can think of different people having different human capital,

and that human capital have different correlations with the market,

that would suggest different people should have different financial portfolios.

They've different human capital.

What's an example?

For example if you're a government worker, you have a fixed salary,

you should probably be investing more in risky assets

than an individual that owns his or her own business.

And therefore their income is maybe much more sensitive to the state of

the economy.

They might want to have a more conservative financial portfolio.

Investing in the company stock of your own employer is a particularly risky strategy,

because your financial assets are tied to how the firm performs, but your future

salary and human capital is also tied to the performance of your company.

Investing in company stocks sets you up for very volatile outcomes.

We kind of did this a little bit before.

Think of a worker at Microsoft or Google that invested all of his or

her retirement plan in company stock.

Ex post these workers are set for life and they would have said, I'm so

glad I didn't listen to you Scott, in talking about the downsides of investing

all of your financial wealth in company stock.

By ignoring you,

putting everything in my company stock, now I get to retire at 50 years old.

But think of the flip side.

Think of a worker at Enron or United Airlines that invested all of his or

her retirement plan in company stock, ex post.

These workers have ruined their retirement.

If your risk averse you put a lot of weight on avoiding this ladder outcome.

Of course, if you're risk loving,

then you're going to take much more risk in your total portfolio,

but just be aware of the risk and the potential downsides that you're taking.

And if individuals are risk-adverse,

they want to minimize the chance of a lose-lose scenario and are willing to give

up some of the chance at the win-win scenario to get the down side protection.

When your investing heavily in the stock of the firm where you work,

it can lead to, this kind of cartoon bomb exploding, or

it can lead to this pot of gold at the end of the rainbow.

And this pot of gold is kind of different things for different people, for

me given my waistline maybe quarter pounders for

life from the nearest nearest McDonald's here.

Company stock investment obviously there's a background risk issue with investing in

your own firm's company stock.

That's a definite con.

But maybe there's a pro.

Maybe the workers that invest in company stock in their retirement plan

actually have good information.

If we see firms where workers invest a lot in company stock, maybe they're

getting a great future return because of their knowledge of the company,

that is a consideration that suggests maybe it's not such a bad idea to have

this portfolio heavily tilted in this one asset, the stock of which you're worth,

because it's an informed investment.

Let's actually look and see some research that was done.

Does company stock investments by workers in their retirement plan

actually predict future performance?

Benartzi, we talked about this 2001 study earlier in the module.

Ranks firms by their investment in company stock in 401K plans in 1993.

There's a across firms.

Some firms the workers are investing a lot in company stock.

Some firms not as much.

Does that amount invest in companies' stock predict future performance?

This was done for the sample of 401K plans at the end of 1993.

Let's look at the future performance of these various companies here.

We break firms into 5 groups.

1 through 5.

Based on the allocation to company stock of the workers

investments in their 401(k) plan.

So, we're looking at the contributions made by the workers,

what fraction are they investing in company stock?

For the 20% bottom of firms, this only averages 5% of their contributions.

For the top 20%, this averages 54% of contributions.

They're putting in more than half of their retirement contributions

into companies stock.

So, the key question is looking forward,

the workers put a lot of their money in company's stock, does that do well?

Do those firms do well?

Do these workers have great inside information?

Not illegal inside information, but just like a sense of when the firms is about

to kind of do well, and therefore they invest around the company stock.

So, Bernatzi looks at a period one year up to four years

after the company's stock investment.

So, given this, we're looking at plans in 1993.

Four year return would be over the period of 1994-1997.

For those 20% of the sample that had the lowest allocation to company stock,

the returns over the next four years cumulatively was 100%.

So, 94-97 was kind of a good year for returns.

So, we have this average return of 101%.

How about those firms where they had the biggest investment in company stock, okay?

Well, in that case it was 103%, right?

Absolutely no difference here.

So, those firms or the workers invested the most in companies stock

compare them to those who are they invested the least.

Absolutely no difference in the terms of the future performance, okay?

Look at this difference five minus one firms where the workers invest a lot in

company stock.

One is where they invest a little bit.

Look at there's a big difference in the amount of company stock

that they invest in by definition.

But if anything those where they invest a lot in company stock they actually perform

a little worse in the future.

But these are all small differences.

The bottom line, this company stock investment by the workers and

retirement plan, not predictive at all of kind of future firm performance.

So, let's stay tuned here to Modules 3 and 4,

if you're interested in this kind of geography based investment.

We're going to talk about this more in the context of the geography of investment

decisions for individual investors.

And their stock portfolios, as well as mutual funds.

And we'll talk about that in Modules 3 and 4.

So, here we looked about our individuals investing in their own firm and

their retirement plan.

In Module 3, we'll look at the performance at individuals in stocks in their home

community.

And we'll also look at a performance in Module 4 of mutual funds of stocks

in their home community.

Is there any information advantage that we see manifest in the performance

of these local investors for in terms of individuals with their stock portfolio and

mutual funds with their stock portfolio.

So, all that coming in Module 3 and 4.

So, key takeaways.

When making decisions regarding financial portfolio decisions,

should take into account your total portfolio of assets and liabilities.

A key example for individuals,

investing in your own firm's company stock exposes you to tremendous risk.

Exposes you either to win-win or loose, loose situations.

So, let's kind of end with a few questions here,

pulls by law, law of answer.

First, from a welfare perspective,

should we potentially be worried about individual investor that invest

a lot in local stocks particularly the stock at his or her employer.

Well, I think by this time in the video, you know the answer to this is yes.

If we think this person is risk adverse,

by investing a lot in an asset that is tied to kind of human capital.

Even if you're investing in the stocks of local companies,

how the local, how your community performs may influence the value of your house,

may influence your future salary because you work for a firm in the community.

If you see a lot of local investment, particularly investment

in the firm where you work, this should be a concern if the person's risk

averse because it's setting you up for win, win, lose, lose outcomes.

So, now one final question to finish out this video.

Slightly different perspective here.

So, from a welfare perspective should we potentially be worried about a mutual fund

that invest a lot in local stock.

So, the prior question should we be worried about an individual

that has a lot of the portfolio in local stocks or the stock that they work.

Here, the question is should we be worried about a mutual fund

that invest a lot in local stocks.

So, let's think about this and then I'll give you my take afterwards.

So, from a welfare perspective, should we be potentially worried about a mutual

fund that invests a lot in local stock?

Well, the answer to that is no.

Because the mutual fund is just a one of many investments

that we can kind of purchase.

So, actually if these local investments buy the mutual fund.

Turn out to be kind of based on good information, I would actually want

the mutual fund to be taking advantage of this local knowledge.

Then me as the kind of investor could buy a Boston mutual fund that

specializes in Boston stocks.

Houston mutual fund that specializes in Houston stocks.

LA mutual fund that specializes in LA stocks, and

I can get diversification by the various mutual funds I buy.

So, the mutual fund investing,

like a lot of local companies,

isn't the same issue as if the final

individual is doing that.

[SOUND]

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