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Fear of the Unknown: Familiarity and Economic Decisions

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  • H. Henry Cao
  • Bing Han
  • David Hirshleifer
  • Harold H. Zhang

Abstract

Evidence indicates that people fear change and the unknown. We model this behavior as familiarity bias in which individuals focus on adverse scenarios in evaluating defections from the status quo. The model explains portfolio underdiversification, home and local biases. More importantly, equilibrium stock prices reflect an unfamiliarity premium. In an international setting, our model predicts that while the standard CAPM fails to hold with respect to the world market portfolio, a modified CAPM holds wherein the market portfolio is replaced with a portfolio of the stock holdings of investors not subject to familiarity bias. Copyright 2011, Oxford University Press.

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  • H. Henry Cao & Bing Han & David Hirshleifer & Harold H. Zhang, 2011. "Fear of the Unknown: Familiarity and Economic Decisions," Review of Finance, European Finance Association, vol. 15(1), pages 173-206.
    • Handle: RePEc:oup:revfin:v:15:y:2011:i:1:p:173-206
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    More about this item

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • F30 - International Economics - - International Finance - - - General
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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