Adaptive behavior leads to under-diversification

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

Research output: Contribution to journalArticlepeer-review

22 Scopus citations

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.

Original languageEnglish
Pages (from-to)985-995
Number of pages11
JournalJournal of Economic Psychology
Volume31
Issue number6
DOIs
StatePublished - Dec 2010
Externally publishedYes

Keywords

  • Adaptation
  • Diversification
  • Learning

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