The Portfolio Composition Effect
82 Pages Posted: 18 Jun 2020 Last revised: 7 Jul 2020
Date Written: July 3, 2020
Does the evaluation of a portfolio of stocks depend on its composition of winner and loser stocks? To test this, we define a simple, counting-based measure of performance – the number of winner relative to the number of loser stocks in a portfolio – and examine how this composition measure affects individuals’ willingness to invest in a portfolio. We derive testable predictions for the proposed composition measure from a framework which combines category-based thinking with mental accounting. Consistent with our predictions, we find across all experiments that individuals allocate larger investments to portfolios with more winner than loser stocks relative to alternative portfolios with more loser than winner stocks, although both portfolios (1) have realized identical overall portfolio returns and (2) show identical expected risk-return characteristics. Building on our experimental findings, we analyze fund flows of exchange-traded funds on leading equity market indices. We identify that the proposed portfolio composition measure is positively related to future net fund flows.
Keywords: Portfolio composition, investment behavior, risk preferences, mental accounting
JEL Classification: G11, G12, G40, D84
Suggested Citation: Suggested Citation