Implications of Heuristics and Biases

for Financial Decision-Making

Chapter 8
FINANCIAL BEHAVIORS STEMMING
FROM FAMILIARITY
1. Home Bias
• Domestic investors overweight domestic stocks.
• Kenneth French and James Poterba documented this tendency.
• Bias toward the home country flies in the face of evidence indicating that
diversifying internationally allows investors to reduce risk without
surrendering return.
• One reason why investors might hold more domestic securities is that they
are optimistic about their markets relative to foreign markets.
• Another behavioral explanation is along the lines of comfort-seeking and
familiarity.
• Rational explanation: International investment may be less attractive because
of institutional barriers, examples of which are capital movement restrictions,
differential trading costs, and differential tax rates.
2. Distance, Culture, and Language
• The argument that institutional considerations cause investors to shy away
from foreign investments becomes weak if it can be demonstrated that
people prefer to invest locally, even within their own country.
• 1984 →AT&T forced into a divestiture → seven “Baby Bells”
• Buy locally, the income of the region is highly correlated, while as per
diversification, investment in another region, “Baby Bells” is preferred.
• Mark Grinblatt and Matti Keloharju demonstrate that the preference for
familiarity extends to language and culture. Finland has two official
languages, Finnish and Swedish.
3. Local Investing and Informational Advantages
• Joshua Coval and Tobias Moskowitz investigated this issue in the context of
mutual fund managerial performance.
• Hedging demands
• Coval and Moskowitz demonstrate a significant payoff to local investing. Fund
managers on average earn 2.67% per year more on local investments, while
local stocks avoided by managers underperform by 3% per year.
• Local investments outperform remote investments by 3.2% per year.
4. Investing in your employer or brand that you know
• Investors overweight the stocks of companies whose brands are familiar or
that they work for.
• Laura Frieder and Avanidhar Subrahmanyam looked at survey data on
perceived brand quality and brand familiarity (recognition) and asked
whether these attributes impacted investor preferences.
• These researchers found that institutional holdings are significantly and
negatively related to brand recognition, but no discernible impact was
present for brand quality.
FINANCIAL BEHAVIORS STEMMING
FROM REPRESENTATIVENESS
1. Good companies Vs. Good investments

Executives are asked to assign values between “0” (poor) and “10” (excellent) to each company in their industry
for the following items:
• quality of management;
• quality of products/services;
• innovativeness;
• Longterm investment value;
• financial soundness;
• ability to attract, develop, and keep talented people;
• responsibility to the community and environment;
• and wise use of corporate assets.

Fortune reports average scores on all attributes as a proxy for company quality, because 82% of respondents
consider quality of management as the most important attribute of a company’s quality,
1. Good companies Vs. Good investments

It is important to understand that no company attribute

should be associated with investment value: all information
on company quality should already be embedded in stock
prices so that all companies (good ones and bad ones) are
equally good investments (on an ex-ante basis).
1. Good companies Vs. Good investments
1. Good companies Vs. Good investments

The tendency for individuals to use representativeness (big

high-growth firms are representative of good investments)
in this context may have contributed to the small-firm and
value anomalies.
2. Chasing winners
• Investors choose securities and investment funds based on past performance.
• Trend-following, or momentum chasing.
• More people become bullish if the market has recently turned up.
• In the context of mutual funds, strong past performance leads to abnormally
high inflows of investor money.
• Momentum Chasing versus contrarian strategy
3. Availability and attention-grabbing
• Brad Barber and Terrance Odean investigated whether information availability
impacts the trading behavior of investors.
• They argue that since attention is a scarce resource and there are a plethora
of possible investment opportunities, the transactions of retail investors are
likely to be concentrated in stocks where information is freely available.
• “Attention-grabbing stocks” is proxied in three ways: news reports on a stock,
unusually high trading volume, and extreme returns.
• Negative news is likely to be ignored, while positive news may attract
purchases. On this basis, these researchers suggest that news is likely to lead
to net purchases for retail investors.
ANCHORING TO AVAILABLE ECONOMIC CUES
1. An experimental study of real estate appraisals

2. Anchoring Vs. Herding (social aspect)

Northcraft, G. B., & Neale, M. A. (1987). Experts, amateurs, and real estate: An anchoring-and-adjustment
perspective on property pricing decisions. Organizational behavior and human decision processes, 39(1), 84-
97.
Bian, T. Y., Huang, J., Zhe, S., & Zhang, M. (2021). Anchoring effects in the Chinese art
market. Finance Research Letters, 43, 102050.