To save us time and energy we often take mental short cuts – and in times of uncertainty we especially seek the reassurance of what we know. We should therefore be aware that we may prioritise the familiar even if it has a harmful effect on our investments.
Familiarity bias is the tendency to opt for more familiar options, even though these often result in less favourable outcomes than available alternatives. It stems from the availability heuristic whereby people make judgments about the likelihood of an event based on how easily an example, instance, or case comes to mind.
Investors who have historically sought out traditional wealth managers have done so because they are attracted to the familiar – for the presumed expertise of professional investors and for the expected security of their capital.
Yet to plan effectively for the future you should consider ditching the enduringly familiar. Investors are increasingly taking this approach: up to a third of clients are planning to change who looks after their money over the next three years according to the EY 2019 Global Wealth Management Research Report, with pricing cited as the number one attribute prompting such moves.
High overall costs play an outsized role when investing, and investors are taking notice. In a survey we conducted with YouGov, 64% of respondents claimed that a high level of charges would make them think about switching to another provider. Yet familiarity’s magnetic embrace is evident: 55% of those questioned have never considered switching from their investment provider.
But they should, especially if they do their sums. Even a 1% difference in overall fees has a significant impact over time. Look at the difference to a £500,000 portfolio when you compare paying 0.65% in fees with 1.65% over 10 and 20 years.
Source: Netwealth. Assumes initial sum of £500k, growth of 5% a year, and a difference in fees of 0.65% vs 1.65%.
The effects of this bias may also manifest itself in ways which may be unfamiliar:
- Previous returns from a wealth manager may have beaten your expectations, but you should be wary of falling under their familiar spell if they try to justify high fees even when performance is not up to scratch. Especially as expected returns in future from equities and fixed income may be lower than previous years and hence agreeing to pay such a high proportion of your return expectation as a fee seems illogical.
- In the familiar world of traditional wealth management, investors may be offered a bespoke portfolio – highlighted as a premium option compared to a model portfolio. But don’t for a second think it is a better option: we believe a bespoke portfolio is more likely to underperform than a centrally managed portfolio and cost you more.
- Favouring the familiar may cause us to prefer to stick with the status quo and be slow to adopt new trends which are beneficial. For example, persisting with active large cap funds even though 90% of these funds underperformed the S&P 500 index in the 15 years to the end of 20181 – a failure which repeatedly plays out in a downturn, too.
Familiarity and availability bias can have many consequences. Yet in many walks of life we are hard-wired to feel reassured by what we know. Reaching out for the familiar is often an innate response and a comfort to those who are enduring a crisis – but when it comes to investing, this tendency won’t necessarily do you any favours.
Please remember that when investing your capital is at risk.
1 Source: S&P Dow Jones Indices, Dec 2018.