Do People Understand the Benefit of Diversification?

forthcoming, Management Science

89 Pages Posted: 22 Jan 2016 Last revised: 20 Oct 2020

See all articles by Nicholas Reinholtz

Nicholas Reinholtz

University of Colorado at Boulder - Leeds School of Business

Philip Fernbach

University of Colorado at Boulder - Department of Marketing

Bart De Langhe

University of Colorado at Boulder

Date Written: October 19, 2018

Abstract

Diversification—investing in imperfectly correlated assets—reduces volatility without sacrificing expected returns. While the expected return of a diversified portfolio is the weighted average return of its constituent parts, the variance of the portfolio is less than the weighted average variance of its constituent parts. Our results suggest that very few people have correct statistical intuitions about the effects of diversification. The average person in our data sees no benefit of diversification in terms of reducing portfolio volatility. Many people, especially those low in financial literacy, believe diversification actually increases the volatility of a portfolio. These people seem to believe that the unpredictability of individual assets compounds when aggregated together. Additionally, most people believe diversification increases the expected return of a portfolio. Many of these people correctly link diversification with the concept of risk reduction, but seem to understand risk reduction to mean greater returns on average. We show that these beliefs can lead people to construct investment portfolios that mismatch investors’ risk preferences. Further, these beliefs may help explain why many investors are underdiversified.

Keywords: diversification, financial decision making, investing, numerical cognition

Suggested Citation

Reinholtz, Nicholas and Fernbach, Philip and Langhe, Bart De, Do People Understand the Benefit of Diversification? (October 19, 2018). forthcoming, Management Science, Available at SSRN: https://ssrn.com/abstract=2719144 or http://dx.doi.org/10.2139/ssrn.2719144

Nicholas Reinholtz (Contact Author)

University of Colorado at Boulder - Leeds School of Business ( email )

Boulder, CO 80309-0419
United States

Philip Fernbach

University of Colorado at Boulder - Department of Marketing ( email )

United States

Bart De Langhe

University of Colorado at Boulder ( email )

1070 Edinboro Drive
Boulder, CO 80309
United States

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