Do People Understand the Benefit of Diversification?
81 Pages Posted: 22 Jan 2016 Last revised: 21 Jun 2018
Date Written: July 12, 2018
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. 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 return. 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
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