Fear of the Unknown: Familiarity and Economic Decisions

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.