Very often, your client’s behaviour determines the outcome of his investments. As human beings, we are all prone to have our own biases. As their advisor, it is your responsibility to guide them to make better choices.
In the article, we will talk about familiarity bias and help you identify them to avoid it.
Familiarity Bias: Confusing familiar with safe
Presented with two stocks, which one would a direct equity investor pick? More often, a software engineer may lean towards an IT stock while a banker may choose a banking stock. This tendency to invest in industries the person understands well is an example of familiarity bias.
Why does this occur?
Having thorough knowledge of an investment helps your client gauge its risks. The client may believe that it is safer to invest in it since he understands the risks well. He may not be comfortable investing in different sectors or asset classes because of lack of knowledge. However, this exposes his portfolio to concentration risk. Moreover, he will miss the benefits of having diversified investments. This will lead to a skewed portfolio and increase his chances of losses.
How to combat it?
Explain the risk:
Help your client understand concentration risk. Give past examples such as tech bubble and infrastructure sector. Also, explain to them about the risk of putting all their investments in a single asset class just because it is familiar to them. For e.g. investing in only debt products like fixed deposits may not give them attractive returns over long term even though they would be very familiar with them.
Datta Kanbargi, a Belgaum based IFA explains the importance of diversification to his clients. “Whenever, I see that a prospective client is investing all his money in a single type of product, I explain to him the importance of diversifying their investments. I describe to him or her how investing in the right mix of assets helps optimise portfolio returns. Additionally, I help him or her understand that just because he or she knows a product does not imply that it is the best investment choice,” he said.
Bengaluru based advisor Srikanth Matrubai of Goodfunds Advisor warns his clients of the perils of over exposure. “Investments act as a financial shield. Assume you have maximum investments in the same sector that you work in. Then any negative movement in the sector will hurt your job prospects as well as your investments. Instead, it is better to diversify your investments to protect you against any untoward risk.”
Educate your client:
Familiarity bias stems from the fear of the unfamiliar. As their advisor, you need to make the unfamiliar familiar so that they explore wider opportunities. Before recommending any product, explain its features, risks and performance history to the client. This will help him understand the product. Consequently, it will reduce the fear of investing in the product from his mind. While the transition will not happen overnight, regularly educating your clients can help you overcome their fears.