Domain-Dependent Diversification: The Influence of Gain-loss Domain on Correlation Choice

Abstract

Despite compelling evidence of widespread gain-loss-domain-dependent behavior, research on domain-dependent diversification is scarce. We recruited 251 experienced US retail investors to participate in a controlled experiment with the task to select portfolios that differ in asset correlation and hence diversification benefits in both the gain and the loss domain. We find evidence of domain-dependent diversification, both unconditional and conditional on benchmark portfolio preferences. Consistent with a loss-attention hypothesis, diversification errors are not observed in the loss domain, but are clearly present in the gain domain (with much lower diversification relative to the benchmark).

Keywords: behavioral finance, experimental finance, diversification, domain dependency, asset correlation, counter-cyclical risk aversion, stock market conditions

JEL Classification: D14, D18, G11, G41