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Fear of the Unknown: Familiarity and Economic Decisions

  • Cao, Henry
  • Han, Bing
  • Hirshleifer, David
  • Zhang, Harold

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.

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File URL: https://mpra.ub.uni-muenchen.de/6512/1/MPRA_paper_6512.pdf
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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 6512.

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Date of creation: 2007
Handle: RePEc:pra:mprapa:6512
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