Naive Diversification Preferences and Their Representation

30 Pages Posted: 4 Nov 2016 Last revised: 18 Mar 2018

See all articles by Enrico G. De Giorgi

Enrico G. De Giorgi

University of St. Gallen - SEPS: Economics and Political Sciences

Ola Mahmoud

University of California, Berkeley; University of Zurich

Date Written: March 11, 2018

Abstract

A widely applied diversification paradigm is the naive diversification choice heuristic. It stipulates that an economic agent allocates equal decision weights to given choice alternatives independent of their individual characteristics. This article provides mathematically and economically sound choice theoretic foundations for the naive approach to diversification. We axiomatize naive diversification by defining it as a preference for equality over inequality, derive its relationship to the classical diversification paradigm, and provide a utility representation. In particular, we (i) prove that the notion of permutation invariance lies at the core of naive diversification and that an economic agent is a naive diversifier if and only if his preferences are convex and permutation invariant; (ii) derive necessary and sufficient conditions on the utility functions that give rise to preferences for naive diversification; (iii) show that naive diversification preferences arise when decision makers only consider beliefs that imply some weak form of independence, which is closely related to correlation neglect.

Keywords: naive diversification, convex preferences, permutation invariant preferences, Schur-concave utility, inequality aversion, majorization, Dalton transfer, Lorenz order

JEL Classification: C02, D81, G11

Suggested Citation

De Giorgi, Enrico G. and Mahmoud, Ola, Naive Diversification Preferences and Their Representation (March 11, 2018). Available at SSRN: https://ssrn.com/abstract=2864231 or http://dx.doi.org/10.2139/ssrn.2864231

Enrico G. De Giorgi

University of St. Gallen - SEPS: Economics and Political Sciences ( email )

Department of Economics
Bodanstrasse 6
CH-9000 St. Gallen
Switzerland
+41712242430 (Phone)

Ola Mahmoud (Contact Author)

University of California, Berkeley ( email )

Center for Risk Management Research
Evans Hall
Berkeley, CA 94720
United States

University of Zurich ( email )

Schönberggasse 1
Zürich, 8001
Switzerland

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