Irrational Diversification: An Examination of the Portfolio Construction Decision
49 Pages Posted: 14 Feb 2009 Last revised: 16 Dec 2011
Date Written: February 11, 2009
We study individual portfolio choice in a laboratory experiment and find strong evidence for heuristic behavior. The subjects tend to focus on the marginal distribution of an asset, while largely ignoring its diversification benefits. They follow a conditional 1/n diversification heuristic as they exclude the assets with an “unattractive” marginal distribution and divide the available funds equally between the remaining, “attractive” assets. This strategy is applied even if it leads to allocations that are dominated in terms of first-order stochastic dominance and is clearly irrational. In line with these findings, we find that framing and problem presentation have substantial influence on portfolio decisions.
Keywords: diversification, framing, financial economics, naive diversification, 1/n heuristic, behavioral finance, bounded rationality
JEL Classification: C91, D14, G11
Suggested Citation: Suggested Citation