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Correlation Neglect, Naïve Diversification, and Irrelevant Information as Stumbling Blocks for Optimal Diversification

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  • Zulia Gubaydullina
  • Markus Spiwoks

Abstract

The paper analyses on an experimental basis the phenomenon of non-optimal diversification in portfolio choice decisions. The main obstacles to achieving optimal diversification are investigated – the correlation neglect hypothesis and information processing, both of which lead to suboptimal diversification decisions. This is possible by constructing the investment alternatives in the experimental design in such a way that the Markowitz efficient frontier is reduced to a single point in the return-risk diagram, enabling unambiguous interpretation of the results. The experiment shows that the subjects are not in a position to use the information that is most relevant to investment alternatives and ignore correlation in making their portfolio choice. Moreover, they are unable to prescind from clearly irrelevant information. The first effect dominates the second – in the absence of irrelevant information, the subjects neglect the correlation between the assets. The effect is even more pronounced with additional irrelevant information. These findings shed more light on individual investment behaviour and pose questions about regulating pension funds to ensure optimal diversification of pension savings.

Suggested Citation

  • Zulia Gubaydullina & Markus Spiwoks, 2015. "Correlation Neglect, Naïve Diversification, and Irrelevant Information as Stumbling Blocks for Optimal Diversification," Journal of Finance and Investment Analysis, SCIENPRESS Ltd, vol. 4(2), pages 1-1.
    • Handle: RePEc:spt:fininv:v:4:y:2015:i:2:f:4_2_1
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    Citations

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    Cited by:

    1. Markus Spiwoks & Kilian Bizer, 2018. "Correlation Neglect and Overconfidence. An Experimental Study," Journal of Applied Finance & Banking, SCIENPRESS Ltd, vol. 8(3), pages 1-5.
    2. Cornil, Yann & Hardisty, David J. & Bart, Yakov, 2019. "Easy, breezy, risky: Lay investors fail to diversify because correlated assets feel more fluent and less risky," Organizational Behavior and Human Decision Processes, Elsevier, vol. 153(C), pages 103-117.
    3. Ibrahim Filiz & Thomas Nahmer & Markus Spiwoks & Kilian Bizer, 2018. "Portfolio diversification: the influence of herding, status-quo bias, and the gambler’s fallacy," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 32(2), pages 167-205, May.
    4. Filiz, Ibrahim & Nahmer, Thomas & Spiwoks, Markus & Gubaydullina, Zulia, 2020. "Measurement of risk preference," Journal of Behavioral and Experimental Finance, Elsevier, vol. 27(C).
    5. Ibrahim Filiz & Jan René Judek & Marco Lorenz & Markus Spiwoks, 2022. "Algorithm Aversion as an Obstacle in the Establishment of Robo Advisors," JRFM, MDPI, vol. 15(8), pages 1-25, August.
    6. Sesil Lim & Bas Donkers & Patrick Dijl & Benedict G. C. Dellaert, 2021. "Digital customization of consumer investments in multiple funds: virtual integration improves risk–return decisions," Journal of the Academy of Marketing Science, Springer, vol. 49(4), pages 723-742, July.

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