Naïve diversification
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Naïve diversification is a choice
heuristic A heuristic (; ), or heuristic technique, is any approach to problem solving or self-discovery that employs a practical method that is not guaranteed to be optimal, perfect, or rational, but is nevertheless sufficient for reaching an immediate, ...
(also known as "diversification heuristic"). Essentially, when asked to make several choices at once, people tend to diversify more than when making the same type of decision sequentially. Its first demonstration was made by
Itamar Simonson Itamar Simonson is a professor of marketing, holding the Sebastian S. Kresge Chair of Marketing in the Graduate School of Business, Stanford University. He is known for his work on the factors that determine the choices that buyers make. His ...
in
marketing Marketing is the process of exploring, creating, and delivering value to meet the needs of a target market in terms of goods and services; potentially including selection of a target audience; selection of certain attributes or themes to emph ...
in the context of consumption decisions by individuals. It was subsequently shown in the context of economic and financial decisions. Simonson showed that when people have to make simultaneous choice (e.g. choose now which of six snacks to consume in the next three weeks), they tend to seek more variety (e.g., pick more kinds of snacks) than when they make sequential choices (e.g., choose once a week which of six snacks to consume that week for three weeks). Subsequent research replicated the effect using a field experiment: on
Halloween Halloween or Hallowe'en (less commonly known as Allhalloween, All Hallows' Eve, or All Saints' Eve) is a celebration observed in many countries on 31 October, the eve of the Western Christian feast of All Saints' Day. It begins the observanc ...
night, young trick-or-treaters were required to make a simultaneous or subsequent choice between the candies they received. The results showed a strong diversification bias when choices had to be made simultaneously, but not when they were made sequentially.
Shlomo Benartzi Shlomo Benartzi is an American behavioral economist, known for his research on retirement savings and the Save More Tomorrow nudge. Benartzi is currently a Professor Emeritus at the UCLA Anderson School of Management in Los Angeles, California. ...
and Richard Thaler commented on Read and Loewenstein's research: "This result is striking since in either case the candies are dumped into a bag and consumed later. It is the portfolio in the bag that matters, not the portfolio selected at each house." Following on the naive diversification showed by children, Benartzi and Thaler turned to study whether the effect manifests itself among investors making decisions in the context of defined contribution saving plans. They found that "some investors follow the '1/n strategy': they divide their contributions evenly across the funds offered in the plan. Consistent with this Naïve notion of
diversification Diversification may refer to: Biology and agriculture * Genetic divergence, emergence of subpopulations that have accumulated independent genetic changes * Agricultural diversification involves the re-allocation of some of a farm's resources to n ...
, we find that the proportion invested in stocks depends strongly on the proportion of stock funds in the plan." This finding is particularly troubling in the context of laypersons making financial decisions, because they may be diversifying in a way that is sub-optimal; see
efficient frontier In modern portfolio theory, the efficient frontier (or portfolio frontier) is an investment portfolio which occupies the "efficient" parts of the risk–return spectrum. Formally, it is the set of portfolios which satisfy the condition that no o ...
. Doron Kliger,
Martijn van den Assem Martijn may refer to: * Martijn (given name), a Dutch given name (including a list of people with the name) * Vereniging Martijn Vereniging Martijn (; "Martijn Association"; stylized as MARTIJN) was a Dutch association that advocated the societ ...
and
Remco Zwinkels Remco Industries, Inc. was a toy company in the United States founded in the 1940s. It was best known for toys marketed and sold in the late 1950s and early 1960s, like the 'Johnny Reb Cannon', 'Mighty Matilda Atomic Aircraft Carrier', 'Remco Voi ...
show that naïve reliance on the diversification rule is not limited to lay people and laboratory subjects. They distributed a questionnaire among behavioral finance researchers who had submitted a paper or had been asked to review a paper for a special issue of the Journal of Economic Behavior and Organization. Such experts are supposedly well-informed about the roles of heuristics and biases in judgment and decision making. The questions related to the relative importance of different types of research in their field. Half of the potential respondents received the version where each question listed two or three possible types. The other half received exactly the same questions, but in their version one of the two or three types was further partitioned into finer components. The results show that these experts heavily relied on the diversification heuristic when they expressed their views about the future of their profession. Daniel Fernandes of the Catholic University of Portugal used a similar procedure to Benartzi and Thaler's experiment to elicit the naïve diversification bias of each individual subject. Respondents were asked to make two hypothetical decisions. In the first decision, respondents had to allocate their savings to five
funds Funding is the act of providing resources to finance a need, program, or project. While this is usually in the form of money, it can also take the form of effort or time from an organization or company. Generally, this word is used when a firm uses ...
, of which four were
stock In finance, stock (also capital stock) consists of all the shares by which ownership of a corporation or company is divided.Longman Business English Dictionary: "stock - ''especially AmE'' one of the shares into which ownership of a company ...
funds. In the second decision, respondents had to allocate their savings to five funds, of which four were
fixed-income Fixed income refers to any type of investment under which the borrower or issuer is obliged to make payments of a fixed amount on a fixed schedule. For example, the borrower may have to pay interest at a fixed rate once a year and repay the pri ...
funds. The results replicate the original finding that respondents were way more likely to invest in stocks when the proportion of stock funds was larger. The naïve diversification bias was observed across many samples (even among professors of finance at the university) and was explained by the extent to which investors use their intuition to decide. The more investors use intuitive judgments, the more they display the naïve diversification bias.{{cite journal , last=Fernandes , first=Daniel , year=2013 , title=The 1/N Rule Revisited: Heterogeneity in the Naïve Diversification Bias, journal=
International Journal of Research in Marketing ''International Journal of Research in Marketing (IJRM)'' is a quarterly peer-reviewed academic journal published by Elsevier. It is an official journal of the European Marketing Academy and the editor-in-chief is Martin Schreier. The Co-Editors ...
, volume=30, issue=3 , pages=310–313 , doi=10.1016/j.ijresmar.2013.04.001, s2cid=153884363


References

Cognitive psychology Financial markets Consumer behaviour Behavioral finance