Rotman Management — Spring 2017

102 / Rotman Management Spring 2017

focal choice with skepticism. For example, people tend to

dislike risks that derive from active choices more than risks

that result from remaining passive. Psychologists have re-

ferred to this as the omission bias, and it explains why indi-

viduals are reluctant to take seemingly risky actions such as

getting vaccinated, often preferring to bear the much bigger

risks associated with remaining passive.

More broadly, psychologists have documented a

strong and robust mere exposure effect: individuals tend to

like stimuli that are more familiar. Advertisers try to take

advantage of this by repeatedly exposing consumers to the

name of a brand, hoping that consumers will use it as a de-

fault choice when they face many similar products.

In general, things that we are familiar with, choice al-

ternatives that fall within our domain of competence, and

default choice alternatives that involve continuing to do

what we were doing previously, will tend to be viewed as

‘less risky’ than new initiatives into unknown territory. As a

result, it makes sense as a general heuristic to favour famil-

iar or status quo choice alternatives. Such a heuristic can go

astray, however, when in fact we possess other clear sources

of information about the distributions of payoffs of different

alternatives.

There is a great deal of evidence suggesting that these

two psychological forces—the tendency to evaluate choices

relative to a focal-choice benchmark, and the tendency to be

unduly skeptical about non-focal choice alternatives — oper-

ate robustly in capital market decisions.

In corporate finance, a manager’s reluctance to termi-

nate an investment, involves holding insistently to a pre-

viously-selected or endowed choice alternative. Previous

studies document that firms commonly use hurdle rates that

exceed the cost of capital, thereby discouraging new proj-

ects. A related phenomenon is the sunk-cost effect, whereby

an initial investment in a project creates reluctance to ter-

minate it.

In the realm of stock investments, individuals have also

been shown to prefer familiar choices. For example, U.S.

investment managers invest disproportionately in locally-

headquartered firms. Researchers have found that custom-

ers of a given U.S. Regional Bell Operating Company

(RBOC) tend to hold more of its shares and invest more

Investors have a greater ‘perceived familiarity’ with local

and domestic securities and, in turn, invest more in them.

Status Quo Deviation Aversion (SQDA) is pervasive in capital markets.

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