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Naïve diversification is a choice
heuristic A heuristic or heuristic technique (''problem solving'', '' mental shortcut'', ''rule of thumb'') is any approach to problem solving that employs a pragmatic method that is not fully optimized, perfected, or rationalized, but is nevertheless ...
(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 in
marketing Marketing is the act of acquiring, satisfying and retaining customers. It is one of the primary components of Business administration, business management and commerce. Marketing is usually conducted by the seller, typically a retailer or ma ...
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 geography of Halloween, observed in many countries on 31 October, the eve of the Western Christianity, Western Christian f ...
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 and
Richard Thaler Richard H. Thaler (; born September 12, 1945) is an American economist and the Charles R. Walgreen Distinguished Service Professor of Behavioral Science and Economics at the University of Chicago Booth School of Business. In 2015, Thaler was p ...
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
investor An investor is a person who allocates financial capital with the expectation of a future Return on capital, return (profit) or to gain an advantage (interest). Through this allocated capital the investor usually purchases some species of pr ...
s 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, 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 suboptimal; 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 n ...
. Doron Kliger, Martijn van den Assem and Remco Zwinkels show that naïve reliance on the diversification rule is not limited to lay people and laboratory subjects. They distributed a questionnaire among
behavioral finance Behavioral economics is the study of the psychological (e.g. cognitive, behavioral, affective, social) factors involved in the decisions of individuals or institutions, and how these decisions deviate from those implied by traditional economi ...
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 The Catholic University of Portugal ( Portuguese: ''Universidade Católica Portuguesa'', pronounced nivɨɾsiˈðad(ɨ) kɐˈtɔlikɐ puɾtuˈɣezɐ, also referred to as Católica or UCP for short, is a concordat university (non-state-run unive ...
used a similar procedure to Benartzi and Thaler's experiment to elicit the naïve diversification bias of each individual subject. Respondents we're 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 us ...
, of which four were
stock Stocks (also capital stock, or sometimes interchangeably, shares) consist of all the Share (finance), shares by which ownership of a corporation or company is divided. A single share of the stock means fractional ownership of the corporatio ...
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 prin ...
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 , 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