Fear of the Unknown: Familiarity and Economic Decisions

48 Pages Posted: 10 May 2007 Last revised: 16 Sep 2009

See all articles by H. Henry Cao

H. Henry Cao

University of North Carolina (UNC) at Chapel Hill - Finance Area

Bing Han

University of Toronto, Rotman School of Management

Harold H. Zhang

University of Texas at Dallas - Naveen Jindal School of Management; China Academy of Financial Research (CAFR)

David A. Hirshleifer

University of California, Irvine - Paul Merage School of Business; NBER

Date Written: December 1, 2007

Abstract

Evidence indicates that people fear change and the unknown. We offer a model of familiarity bias in which individuals focus on adverse scenarios in evaluating defections from the status quo. The model explains the endowment effect, portfolio underdiversification, home and local biases. Equilibrium stock prices reflect an unfamiliarity premium. In an international setting, our model implies that the absolute pricing error of the standard CAPM is positively correlated with the amount of home bias. It also predicts that a modified CAPM holds wherein the market portfolio is replaced with a portfolio of the stock holdings of investors not subject to familiarity bias.

Keywords: familiarity, model uncertainty, status quo, home bias, diversification, inertia

JEL Classification: G10, G11, G12

Suggested Citation

Cao, Huining Henry and Han, Bing and Zhang, Harold Huibing and Hirshleifer, David A., Fear of the Unknown: Familiarity and Economic Decisions (December 1, 2007). Available at SSRN: https://ssrn.com/abstract=985381 or http://dx.doi.org/10.2139/ssrn.985381

Huining Henry Cao

University of North Carolina (UNC) at Chapel Hill - Finance Area ( email )

Kenan-Flagler Business School
Chapel Hill, NC 27599-3490
United States

Bing Han (Contact Author)

University of Toronto, Rotman School of Management ( email )

Toronto, Ontario M5S 3E6
Canada
4169460732 (Phone)

Harold Huibing Zhang

University of Texas at Dallas - Naveen Jindal School of Management ( email )

P.O. Box 830688
Richardson, TX 75083-0688
United States

China Academy of Financial Research (CAFR)

1954 Huashan Road
Shanghai P.R.China, 200030
China

David A. Hirshleifer

University of California, Irvine - Paul Merage School of Business ( email )

Irvine, CA California 92697-3125
United States

HOME PAGE: http://sites.uci.edu/dhirshle/

NBER ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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