Fixed Income

The risk of familiarity bias in asset allocation

Familiarity bias is like being at a party where it’s easier to chat with friends than mingle with strangers — but it can lead to sub-optimal diversification as investors stick to familiar ‘go to’ assets, rather than exploring the full universe of options.

24/11/2018

Mihkel Kase

Mihkel Kase

Fund Manager, Fixed Income

Making investment decisions in a world of uncertainty can be difficult, time consuming and sometimes stressful. In an attempt to cut through this some investors may be tempted to take an easier path and invest mainly in assets that they are familiar with, and hence they feel more comfortable invested in.

The issue is that this approach can lead to, among other problems, the underestimation of risk, which can in turn can lead to investments and portfolio positioning that is suboptimal and potentially hazardous to your wealth.

Familiarity bias

Familiarity bias occurs when an investor has a preference for a familiar investment despite there being other viable options that can also add to portfolio diversification. An asset they have owned before and have had a positive experience can feel less risky and hence is often the “go to” asset when looking to generate returns. Sort of like the ease of catching up with an old friend.

Of course, there are other reasons as to why assets are held in portfolios. Holding an asset over a long period of time doesn’t mean you are exhibiting familiarity bias. Rather, the bias occurs when the investment process, or rather lack thereof, results in choosing assets that ‘feel’ easier, rather than adequately considering those in the broader set of possible assets.

The point is that the filter of familiarity is a behavioral bias, not a repeatable investment process. Investment decisions should be based on factors including valuations, risks, volatility and correlations to other assets.

The result of familiarity bias is that it can overly influence portfolio construction, and hence investment outcomes. It can result in investors excluding a wide range of valid investments for reasons other than the investment case. It can tend to include assets on factors less related to valuations and well-considered investment ideas. If we go back to the friend analogy: it’s like being at a party where it’s easier to chat to someone you know than make the effort to speak to a stranger.

The end outcome is portfolio allocations that are likely suboptimal. 

Examples of familiarity bias

1. One example of familiarity bias is often seen in the use of domestic listed hybrids in a client portfolio. Hybrids appear to fulfill the income requirement as the stated credit spread is above cash, and hence on the face of it fits with the income goal in a portfolio. They are easily accessible as they can be traded on the ASX, and are heavily promoted by brokers. The issuers are familiar, given they are predominately the big banks and issued regularly as can be seen by CBA recently issuing its 11th listed hybrid under the PERLS banner.

We know that hybrids are deeply subordinated and can exhibit high levels of volatility and are considerably risker than cash. The market continues to change compared to when they were first issued (more on that in my next piece). They now display significantly different risks then when first started being issued back in the late 90s. Interestingly, retail investors in some overseas jurisdictions have been prohibited from directly investing in them in their home countries.

2. Another example of familiarity bias can be seen in the use of term deposits (TDs) to the exclusion of other assets. TDs have a known return, however are typically short in tenor (less than one year) and are exposed to reinvestment risk. While they yield above cash they do not provide access to term or credit risk premia, and hence are not a complete portfolio solution.

If you combine these two examples of investor bias it is easy to see how some investors have their non-equity portion of their portfolios overexposed to hybrids and cash, to the exclusion of the remainder of the global fixed income universe.

We are not suggesting hybrids or TDs are necessarily inappropriate in portfolios. On the contrary, the two are within our investible universe and we have varying exposures to them across portfolios. The issue comes around the decision on how much should you hold, and when should you hold it.

Another approach

The approach we use is based on a repeatable investment process. We have clearly framed risk and return objectives and access the full investment opportunity set in seeking to achieve outcomes. Having not only a return objective but a focus on downside risk avoidance is, in our opinion, important.

Being able to access the full opportunity set and objectively assessing each asset on its merits, along with a clear understating of the role each asset will play, provides the best way to deliver regular income as well as manage the total portfolio risk.

The Schroder Absolute Return Income Fund can access credit risk premium across different geographies, tenors, credit quality and capital structures in both listed and unlisted space. Duration can be used as a source of income that can deliver term risk premium but can also assist in managing downside risk. Currencies can assist in managing downside risk, and can be particularly useful when duration may be expensive.  This Fund combines credit, duration and currencies with the flexibility and agility to implement.

Familiarity bias can lead to suboptimal portfolio outcomes where investors underprice risk and can end up with portfolios that lack sufficient diversification and risk management overlays. By looking beyond familiar asset classes and seeking opportunities in other areas, investors can access alternate sources of income and achieve greater portfolio diversification. While risks will continue to exist, a diversified multi-strategy approach is the best way manage these risks and deliver income. 

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