Familiarity breeds contempt, or so the old saying goes. But in investing, it often breeds something else: a false sense of security that can devastate your returns.
Familiarity bias in action
Familiarity bias is most commonly seen when employees put all of their 401(k) contributions into shares of their employer. After all, what business could investors know better than the one for which they work? Perhaps none, but our comfort level with an employer can blind us to the risks of our having investment dollars and regular income all dependent on that single company's success.
For a spectacular example, look no further than Enron. Many of its employees parked a majority of their retirement savings in its stock before the company collapsed. But this sort of thing happens all the time on a smaller scale. Here are a few names whose familiarity makes shares appear tempting -- despite their dangers.
Big brand names get us every time
I suspect that many investors who purchased Bank of America (NYSE: BAC ) or Morgan Stanley (NYSE: MS ) when they first looked cheap, and National City before it was swallowed by PNC Financial Services Group (NYSE: PNC ) , did so because of their familiarity with the company's brands and historical results.
Because we see their brands advertised all the time, and because their offices dot the landscape, these companies become easily recognizable and familiar in our minds. So it's easy to forget that these are also very complex firms with multiple business units and hundreds of competitors. Meanwhile, small, less recognizable community banks such as Suffolk Bancorp and Danvers Bancorp (Nasdaq: DNBK ) often don't get a second glance, despite their sturdy capitalization and growing loan books.
The danger of familiar industries
As the economy contracts, we're drawn to falling prices as a sign of value and potentially large future returns. As an investor who's constantly screening for bargains, I readily admit that I fall into this camp. Since most of us are familiar with retail brands, single-digit P/Es on Guess? (NYSE: GES ) and Limited Brands (NYSE: LTD ) look mighty attractive on the surface. But that's true only if the margins and earnings from the past 12 months even vaguely represent what the businesses will experience in the next three years.
In his annual letter to shareholders, legendary value investor Seth Klarman noted that because of rising unemployment, consumer spending might be experiencing "semi-permanent" changes, rather than a cyclical decline. Data from Bloomberg, showing that the savings rate is rising as consumers cut back on mortgage and credit card debt for the first time since 1952 (at least), supports Klarman's claim about shifting consumer habits.
That doesn't mean all retail should be avoided, but it does mean thinking carefully about a retailer's offerings, and what gives it an advantage over the competition.
The cost of ignoring unfamiliar places
Many U.S. investors pass over international markets, because they don't want to add the uncertainty of foreign politics and currencies to their portfolios. That's understandable on the surface, but it becomes a bit absurd when you consider that studies show that European and Japanese investors have the same bias toward investing in foreign securities.
In normal times, this bias might mean missing an opportunity in Brazil-based energy giant Petrobras (NYSE: PBR ) when its shares are attractive. But at a time when uncertainty surrounds the dollar and the U.S. economy alike, ignoring international markets makes even less sense. PIMCO's master investor Mohamed El-Erian seems to think so, too. In a recent Kiplinger interview, El-Erian noted that international markets are one of the few areas likely to deliver sustainable growth over the next few years, while the U.S. recovers from its debt hangover.
How you can battle familiarity
In his book Your Money and Your Brain, Jason Zweig highlights at least two ways we can help combat familiarity bias. First, diversify -- both within your portfolio and between the portfolio and the income you earn from working. Second, write down your reasons for purchasing an investment immediately after making the purchase. This creates a record of your thought process, forces you to confront your reason for owning a stock, and can help you avoid falling into the trap of familiarity.
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This article was originally published on March 24, 2009. It has been updated.
Nathan Parmelee is co-advisor of Global Gains. He owns preferred shares in Wells Fargo. Petroleo Brasileiro is a Motley Fool Income Investor pick. Limited Brands used to be an Income Investor and an Inside Value recommendation. The Fool has a disclosure policy.