Individual investing in the familiar and the unfamiliar

Abhishek Varma

doi:10.7273/000006196

Using a discount brokerage house data for the period January 1991 November 1996, my thesis explores aspects of individual investing behavior in familiar and unfamiliar assets. Behavioral portfolio theory postulates that individuals divide their portfolio into layers of assets with different levels of risk and each of these layers are associated with different aspirations. Individuals are likely to perceive familiar assets to be less risky. I explore familiarity in the following contexts: (1) Individuals frequently repurchasing (purchasing stocks that were previously sold) stocks, and (2) Individuals purchasing their local utility stocks. In the riskier layer of an individual aimed at a shot for the riches, I explore investments in Over-the-counter (OTC) stocks, unfamiliar to most individuals. Similar to findings in retirement studies focused on employee allocations of their 401(k) plans to their company s stock, I find that repurchases are driven by the interaction of investor preference for familiar stocks and extrapolation of prior roundtrip trade returns. There is no evidence that the repurchasing strategy outperforms a buy and hold strategy. I attribute the sub-optimality of repurchases to commission costs and under-diversification of portfolios, which are magnified for households repurchasing at higher frequencies. Individuals in my dataset are nearly four to five times more likely to purchase stocks of their local direct utility as opposed to utility companies operating outside their state of residence. My tests reveal that individuals do not possess superior or private information about their local utilities, nor are they using their local utility stocks as a hedge for possible increase in their utility expenditure. Indeed, individual preference for their local utility stocks seems to be driven by preference for familiar assets, referred to as familiarity bias. Lastly, I explore commonly held beliefs about individuals investing in OTC stocks, presumably unfamiliar assets. Contrary to popular perceptions associated with gambler or lottery buyers, I find that investors are older, wealthier and more experienced at investing than their counterparts. Individuals investing in OTC stocks display a greater degree of diversification and have large portfolio turnovers.

Individual investing in the familiar and the unfamiliar

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