Circle of Incompetence: Sense of Understanding as an Improper Guide to Investment Risk

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 of future stock performance that had lower...

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Bibliographic Details
Published in:Journal of marketing research 2018-08, Vol.55 (4), p.474-488
Main Authors: LONG, ANDREW R., FERNBACH, PHILIP M., DE LANGHE, BART
Format: Article
Language:English
Subjects:
Correlation analysis
Decision making
Heuristic
Investments
Marketing
Papal documents
Risk aversion
Studies
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Summary: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 of future stock performance that had 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 the authors 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.
ISSN:0022-2437
1547-7193
DOI:10.1509/jmr.16.0429