Consumers incorrectly rely on their sense of understanding of what a company does to evaluate investment risk. In three correlational studies, greater sense of understanding was associated with lower risk ratings (Study 1) and with prediction distributions for future stock performance with lower standard deviations and higher means (Studies 2 and 3). In all studies, sense of understanding was unassociated with objective risk measures. Risk perceptions increased when we degraded sense of understanding by presenting company information in an unstructured versus structured format (Study 4). Sense of understanding also influenced downstream investment decisions. In a portfolio construction task, both novices and seasoned investors allocated more money to hard-to-understand companies for a risk-tolerant client relative to a risk-averse one (Study 5). Study 3 ruled out an alternative explanation based on familiarity. The results may explain both the enduring popularity and common misinterpretation of the "invest in what you know" philosophy.

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Long , Andrew R.; Fernbach , Philip M.; De Langhe, Bart

Circle of incompetence: Sense of understanding as an improper guide to investment risk

08/2018
Consumers incorrectly rely on their sense of understanding of what a company does to evaluate investment risk. In three correlational studies, greater sense of understanding was associated with lower risk ratings (Study 1) and with prediction distributions for future stock performance with lower standard deviations and higher means (Studies 2 and 3). In all studies, sense of understanding was unassociated with objective risk measures. Risk perceptions increased when we degraded sense of understanding by presenting company information in an unstructured versus structured format (Study 4). Sense of understanding also influenced downstream investment decisions. In a portfolio construction task, both novices and seasoned investors allocated more money to hard-to-understand companies for a risk-tolerant client relative to a risk-averse one (Study 5). Study 3 ruled out an alternative explanation based on familiarity. The results may explain both the enduring popularity and common misinterpretation of the "invest in what you know" philosophy.
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Circle of incompetence: Sense of understanding as an improper guide to investment risk
Long , Andrew R.; Fernbach , Philip M.; De Langhe, Bart
Journal of Marketing Research
Vol. 55, n 4, 08/2018, p. 474 - 488

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