Fear of the Unknown: Familiarity and Economic Decisions
48 Pages Posted: 10 May 2007 Last revised: 16 Sep 2009
Date Written: December 1, 2007
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: Suggested Citation