Do People Understand the Benefit of Diversification?
36 Pages Posted: 22 Jan 2016
Date Written: January 20, 2016
Diversification — investing in imperfectly correlated assets — reduces expected volatility without sacrificing expected returns. While the expected return from a diversified portfolio is just the weighted average mean of its constituent parts, the expected variance is less than the weighted average variance of its constituent parts. We demonstrate that very few people have correct statistical intuitions about the effects of diversification. Many people, especially those low in financial literacy, believe diversification increases the volatility of a portfolio because they conflate the predictability of individual assets with the aggregate predictability of the portfolio. Additionally, most people, but especially those high in financial literacy, believe diversification increases the expected return of a portfolio. These errors lead people to construct investment portfolios that mismatch investors’ risk preferences. The fact that people do not understand the benefit of diversification may partially explain why investors are poorly diversified, despite valuing risk reduction.
Keywords: diversification, financial decision making, investing, numerical cognition
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