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Preliminary Version Comments Welcome Fear of The Unknown : The Effects of Familiarity on Financial Decisions

Experimental and capital market evidence indicates that individuals prefer proximate and familiar investments; sticking to current consumption/investment positions, and choice alternatives positioned as default options. We offer an integrated explanation for these effects based upon fear of change and of the unfamiliar. We model fear of change as a tendency for individuals, in evaluating deviations from familiar choices in the face of model uncertainty, to focus on the worst-case scenarios. Individuals evaluate buying versus selling under different probability distributions, which induces a gap between willingness to pay and willingness to accept that increases with both the degree of uncertainty and risk. Similar reasoning applies to preference for the status quo options, and excessive inertia in individual choices. The model thereby offers an explanation for the limited diversification of investors; special cases include the home bias puzzle and the preference of individuals to invest in company stock. In calibrations we find that individuals may hold relatively few asset classes in their portfolios; and that the observed magnitude of home bias can be consistent with a reasonable level of model uncertainty. The model also offers an explanation for attention effects wherein a large amount of publicity for a stock increases demand for it even if the news is on average neutral.