The psychology of diversification : Novice investors’ ability to spread risks

Abstract

In order to reduce risk, portfolio theory prescribes holding a stock portfolio that is diversified across industries and countries. This thesis investigates novice investors’ ability to compile well-diversified portfolios and to what extent psychological factors may affect diversification. In Study I a sample of 10,999 randomly selected citizens’ choices of mutual funds in the Swedish public premium pension scheme (PPS) was analysed. Among those who did not choose the default fund it was typical to include as many funds as were allowed (five) in a portfolio and to use a 1/n heuristic, allocating investments evenly across the selected funds. While thus superficially well-diversified, portfolios were often home biased (overrepresentation of Swedish funds) and possibly influenced by extremeness aversion (overrepresentation of medium-risk funds). Study II replicated these findings in an Internet-survey where 392 university employees made a fictitious choice of PPS funds. Highly involved individuals included a larger number of funds in their portfolio but were not less home biased. Suggesting that investment experience does not improve diversification, individuals who own stock (outside the PPS) were not less home biased. In Study III undergraduates made hypothetical investments, choosing between stock funds that were stripped of all characteristics except for their past (Experiment 1) or expected (Experiments 1 and 2) returns. In Experiment 1 (N = 40) participants paid more attention to the volatility of individual funds than to the volatility of aggregated portfolios. In Experiment 2 (N = 46) a majority diversified even when this increased risk due to covariation between individual funds’ returns. In Experiment 3 (N = 48) nearly half of those who seemingly attempted to minimize risk diversified even when this increased risk. These results suggest that novice investors neglect covariation when diversifying across investment alternatives. Study IV replicated and modified Experiment 2 in Study III. Undergraduates (N = 160) were randomly assigned to one of five conditions with varying instructions. Being instructed to minimize risk, many diversified even when this increased risk. Choices were not markedly improved by informing participants of how covariation affects portfolio risk. Only when being instructed to systematically calculate the returns of diversified portfolios, was covariation neglect reduced. In sum, the results of Studies I-IV suggest that novice investors have an insufficient understanding of what portfolio diversification is essentially about: combining assets which returns are not likely to covary. The results hint at a deep-rooted inability to grasp the concept of covariation, possibly hampering acquisition of adequate knowledge. It is hypothesized that naïve heuristic diversification may be a residual of a default cognitive strategy to seek variety for the sake of learning about the environment.