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Second-order uncertainty and naive diversification

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  • Mahmoud, Ola

Abstract

This paper introduces a new model for decision making under ambiguity called second-order uncertainty. The decision maker considers all probability distributions associated with the given options, and chooses the allocation that minimizes the variability of outcome across all probabilities. Optimal allocation under second-order uncertainty is the equal weighted allocation, also called naive diversification.

Suggested Citation

  • Mahmoud, Ola, 2022. "Second-order uncertainty and naive diversification," Economics Letters, Elsevier, vol. 216(C).
    • Handle: RePEc:eee:ecolet:v:216:y:2022:i:c:s0165176522001574
    DOI: 10.1016/j.econlet.2022.110554
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    References listed on IDEAS

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    1. Cohen, Michele & Jaffray, Jean-Yves, 1980. "Rational Behavior under Complete Ignorance," Econometrica, Econometric Society, vol. 48(5), pages 1281-1299, July.
    2. Barberis, Nicholas & Thaler, Richard, 2003. "A survey of behavioral finance," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, edition 1, volume 1, chapter 18, pages 1053-1128, Elsevier.
    3. Baltussen, Guido & Post, Gerrit T., 2011. "Irrational Diversification: An Examination of Individual Portfolio Choice," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 46(5), pages 1463-1491, October.
    4. Richard H. Thaler & Shlomo Benartzi, 2001. "Naive Diversification Strategies in Defined Contribution Saving Plans," American Economic Review, American Economic Association, vol. 91(1), pages 79-98, March.
    5. Harry Markowitz, 1952. "Portfolio Selection," Journal of Finance, American Finance Association, vol. 7(1), pages 77-91, March.
    6. Fernandes, Daniel, 2013. "The 1/N Rule revisited: Heterogeneity in the naïve diversification bias," International Journal of Research in Marketing, Elsevier, vol. 30(3), pages 310-313.
    7. Prasanta K. Pattanaik & Yongsheng Xu & Walter Bossert, 2000. "Choice under complete uncertainty: axiomatic characterizations of some decision rules," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 16(2), pages 295-312.
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    More about this item

    Keywords

    Second-order uncertainty; Ambiguity; Naive diversification; Principle of indifference;
    All these keywords.

    JEL classification:

    • D01 - Microeconomics - - General - - - Microeconomic Behavior: Underlying Principles
    • D80 - Microeconomics - - Information, Knowledge, and Uncertainty - - - General
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty

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