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Do People Understand the Benefit of Diversification?

36 Pages Posted: 22 Jan 2016  

Nicholas Reinholtz

University of Colorado at Boulder - Leeds School of Business

Philip M. Fernbach

University of Colorado at Boulder - Department of Marketing

Bart De Langhe

University of Colorado at Boulder

Date Written: January 20, 2016

Abstract

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

Suggested Citation

Reinholtz, Nicholas and Fernbach, Philip M. and Langhe, Bart De, Do People Understand the Benefit of Diversification? (January 20, 2016). 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 M. 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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