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Fatal attraction of the familiarity bias

diversification, familiarity bias, investing

Invest in what you know – that’s Investment 101. But could sticking to what you’re comfortable with actually be burning a hole in your pocket?

It’s true that when you know an investment inside out, and the sector it sits in, you’re more likely to successfully evaluate risk and uncover profitable trading opportunities. You don’t have to know what you’re investing in to make money, although it certainly helps.

But just because you know something, doesn’t make it safe. Although it’s easier to achieve diversification than ever before, many investors fall victim to the familiarity bias, where they’re more likely to consider investments in what they know and can easily understand – whether it be the retail sector, oil market or government bonds, for example.

This leaves portfolios with heavy exposure to similar risks and investment cycles, which can mean a greater chance of loss. For example, whilst the slump in oil prices has been good for prices at the pump and those travelling abroad, investors with heavy oil-based portfolios will have had a painful few years as low prices hit earnings and threatened bond repayments.

Investors are also more likely to consider investments at home over other international opportunities. More comfortable with understanding domestic risk and return, this preference for home investments is due to uncertainty over international markets. Yet investors are leaving themselves more exposed to regional economic cycles and currency swings.

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Diversification

With the main actors of the global stage braced for uncertainty, diversification across asset classes and currency is crucial. As equities, bonds and cash rarely perform in tandem, investors should use these asset classes as the building blocks for portfolio construction – topped up with commodities and real estate exposure.

Achieving diversification that’s true to the size of your investment can be hard work and take a lot of time. It’s also not a one-time job, you’ll need to keep on top of sentiment and trends, and regularly rebalance your portfolio.

Exchange traded funds are a popular solution for the time-stretched retail investor and institutional money-maker alike. By tracking the performance of an index or pool of investments, ETFs can offer a low-cost and transparent way to achieve diversification across asset classes and currencies in your portfolio.

International exposure can have a huge impact on returns. In fact, Money Observer just published some interesting research on the performance of the new diversified kids on the block – the robo-advisers. At Moneyfarm, our exposure to US equity paid off in the face of sterling’s post-EU referendum fall.

And as Brexit negotiations ramp-up over the next two-years and the global noise gets louder, diversification will be crucial for portfolio stability.

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