Moderation by Extremes: Biases in Reward Perceptions Drive Compromise Effects in Financial Bundles

Abstract

Considerable research demonstrates a “compromise effect” showing preference for “middle” options. Yet, in the context of bundles, the “middle” option in a choice set can be composed in multiple ways. First, a bundle may include only purely moderate options (e.g., individual stocks moderate in both risk and reward). Alternately, a bundle may include equal numbers of both extreme alternatives (e.g., half high-risk/high-reward and half low-risk/low reward stocks), such that moderate attribute levels exist in the aggregate, but not for any single item. Using stock and lottery portfolios, we find that compromise effects are stronger when consumers are offered middle options that bundle extremes together. This occurs because the bundle-of-extremes is erroneously viewed as more potentially rewarding, but not more risky than a bundle-of-pure-moderation. Importantly, exposing people to simulated information about potential outcomes, such that consumers can better recognize potential downsides of the bundle-of-extremes option, mitigates this preference.

Keywords: financial portfolio; compromise effect; extremeness aversion; bundles; risk; reward

JEL Classification: D81, D11, G11, C91