Irrational Diversification: An Examination of the Portfolio Construction Decision

49 Pages Posted: 14 Feb 2009 Last revised: 16 Dec 2011

See all articles by Guido Baltussen

Guido Baltussen

Erasmus University Rotterdam (EUR); Robeco Asset Management - Quantitative Investing

Thierry Post

Graduate School of Business of Nazarbayev University

Date Written: February 11, 2009

Abstract

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

Baltussen, Guido and Post, Thierry, Irrational Diversification: An Examination of the Portfolio Construction Decision (February 11, 2009). Journal of Financial and Quantitative Analysis (JFQA), Vol. 46, No. 5, 2011. Available at SSRN: https://ssrn.com/abstract=1343021 or http://dx.doi.org/10.2139/ssrn.1343021

Guido Baltussen (Contact Author)

Erasmus University Rotterdam (EUR) ( email )

Burgemeester Oudlaan 50
3000 DR Rotterdam, Zuid-Holland 3062PA
Netherlands

Robeco Asset Management - Quantitative Investing ( email )

Rotterdam, 3011 AG
Netherlands

Thierry Post

Graduate School of Business of Nazarbayev University ( email )

53 Kabanbay Batyra Avenue
Astana, 010000
Kazakhstan

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