Biases in Allocation Under Risk and Uncertainty: Partition Dependence, Unit Dependence, and Procedure Dependence

37 Pages Posted: 19 Jul 2005

See all articles by Craig R. Fox

Craig R. Fox

University of California, Los Angeles (UCLA) - Anderson School of Management

Thomas Langer

University of Muenster - Finance Center

Date Written: May 10, 2005

Abstract

Previous studies of employee investment in retirement plans suggest that people typically naively diversify their investment funds, tending to allocate 1/n of the total to each of n available instruments (Benartzi & Thaler, 2001). In this paper we provide experimental evidence that this bias extends to allocation among simple chance prospects and demonstrate three new violations of rational choice theory implied by use of the naieve diversification strategy. Study 1 demonstrates "partition dependence" in which participants' allocations among a fixed set of investments varies with the hierarchical structure of the option set (e.g., by vendor and instrument). Study 2 demonstrates "unit dependence" in which participants' preferred allocations vary with the metric in which the investment is reported (dollars versus number of shares). Study 3 demonstrates "procedure dependence" in which the bias toward even allocation disappears if participants are asked to choose from a menu of possible portfolios. We show that these results extend to sophisticated participants, simple well-specified gambles and incentive-compatible payoffs. We close with a discussion of theoretical and prescriptive implications.

Keywords: Risk, uncertainty, allocation, diversification, investment, bias

JEL Classification: D31, G11, G31

Suggested Citation

Fox, Craig R. and Langer, Thomas, Biases in Allocation Under Risk and Uncertainty: Partition Dependence, Unit Dependence, and Procedure Dependence (May 10, 2005). Available at SSRN: https://ssrn.com/abstract=757787 or http://dx.doi.org/10.2139/ssrn.757787

Craig R. Fox

University of California, Los Angeles (UCLA) - Anderson School of Management ( email )

110 Westwood Plaza
Los Angeles, CA 90095-1481
United States

Thomas Langer (Contact Author)

University of Muenster - Finance Center ( email )

Universitatsstr. 14-16
Muenster, 48143
Germany
+49 251 83 22033 (Phone)

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