Do people understand the benefit of diversification?
Reinholtz, Nicholas Fernbach, Philip M. De Langhe, Bart
Reinholtz, Nicholas
Fernbach, Philip M.
De Langhe, Bart
Citations
Altmetric:
Publication Type
Journal article with impact factor
Editor
Supervisor
Publication Year
2021
Journal
Management Science
Book
Publication Volume
67
Publication Issue
12
Publication Begin page
7322
Publication End page
7343
Publication NUmber of pages
Collections
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.
Research Projects
Organizational Units
Journal Issue
Keywords
Diversification