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Adaptive behavior leads to under-diversification

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  • Zion, Uri Ben
  • Erev, Ido
  • Haruvy, Ernan
  • Shavit, Tal

Abstract

In a given period, a diversified fund, by virtue of being a weighted average, will perform somewhere in the middle range of its components' respective performances. This means that adaptive investors who look to the past to adjust expectations about future returns will shun diversified funds. That is, adaptive reaction to feedback implies under-diversification when the investor gets complete feedback on the performance of the diversified fund as well as its components in a given period. Three laboratory experiments and one quasi field experiment explore this possibility and its implications. We find that the availability of complete feedback drastically reduces diversification. Under-diversification is observed even when the decision makers receive a complete description of the payoff distributions and when under-diversification lowers expected return.

Suggested Citation

  • Zion, Uri Ben & Erev, Ido & Haruvy, Ernan & Shavit, Tal, 2010. "Adaptive behavior leads to under-diversification," Journal of Economic Psychology, Elsevier, vol. 31(6), pages 985-995, December.
    • Handle: RePEc:eee:joepsy:v:31:y:2010:i:6:p:985-995
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    2. Eyal Ert & Ido Erev, 2013. "On the descriptive value of loss aversion in decisions under risk: Six clarifications," Judgment and Decision Making, Society for Judgment and Decision Making, vol. 8(3), pages 214-235, May.
    3. Peiran Jiao, 2015. "The Double-Channeled Effects of Experience on Individual Investment Decisions: Experimental Evidence," Economics Series Working Papers 766, University of Oxford, Department of Economics.
    4. repec:cup:judgdm:v:9:y:2014:i:5:p:373-386 is not listed on IDEAS
    5. Olschewski, Sebastian & Diao, Linan & Rieskamp, Jörg, 2021. "Reinforcement learning about asset variability and correlation in repeated portfolio decisions," Journal of Behavioral and Experimental Finance, Elsevier, vol. 32(C).
    6. Nax, Heinrich H. & Burton-Chellew, Maxwell N. & West, Stuart A. & Young, H. Peyton, 2016. "Learning in a black box," Journal of Economic Behavior & Organization, Elsevier, vol. 127(C), pages 1-15.
    7. Judith Avrahami & Yaakov Kareev & Einav Hart, 2014. "Taking the sting out of choice: Diversification of investments," Judgment and Decision Making, Society for Judgment and Decision Making, vol. 9(5), pages 373-386, September.
    8. Benzion, Uri & Krupalnik, Lena & Rosenfeld, Ahron & Shahrabani, Shosh & Shavit, Tal, 2012. "The effect of short-term information on long-term investment: An experimental study," Economics Letters, Elsevier, vol. 116(1), pages 20-22.
    9. Malul, Miki & Rosenboim, Mosi & Shavit, Tal, 2013. "So when are you loss averse? Testing the S-shaped function in pricing and allocation tasks," Journal of Economic Psychology, Elsevier, vol. 39(C), pages 101-112.
    10. Nax, Heinrich H. & Burton-Chellew, Maxwell N. & West, Stuart A. & Young, H. Peyton, 2016. "Learning in a black box," LSE Research Online Documents on Economics 68714, London School of Economics and Political Science, LSE Library.

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