Do People Understand the Benefit of Diversification?

Nicholas Reinholtz (), Philip M. Fernbach () and Bart de Langhe ()
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Nicholas Reinholtz: Department of Marketing, Leeds School of Business, University of Colorado Boulder, Boulder, Colorado 80309
Philip M. Fernbach: Department of Marketing, Leeds School of Business, University of Colorado Boulder, Boulder, Colorado 80309
Bart de Langhe: Department of Marketing, Universitat Ramon Llull, ESADE, 08172 Sant Cugat des Valles, Spain

Management Science, 2021, vol. 67, issue 12, 7322-7343

Abstract: Diversification—investing in imperfectly correlated assets—reduces volatility without sacrificing expected returns. Although the expected return of a diversified portfolio is the weighted average return of its constituent parts, the variance of the portfolio is less than the weighted average variance of its constituent parts. Our results suggest that very few people have correct statistical intuitions about the effects of diversification. The average person in our data sees no benefit of diversification in terms of reducing portfolio volatility. Many people, especially those low in financial literacy, believe diversification actually increases the volatility of a portfolio. These people seem to believe that the unpredictability of individual assets compounds when aggregated together. Additionally, most people believe diversification increases the expected return of a portfolio. Many of these people correctly link diversification with the concept of risk reduction but seem to understand risk reduction to mean greater returns on average. We show that these beliefs can lead people to construct investment portfolios that mismatch investors’ risk preferences. Furthermore, these beliefs may help explain why many investors are underdiversified.

Keywords: diversification; financial decision making; investing; numerical cognition; judgment and decision making (search for similar items in EconPapers)
Date: 2021
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Citations: View citations in EconPapers (8)

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