Thursday, April 4, 2013

The Diversification Paradox: Covariance Information and Risk Perception Among Lay Investors

Read the working paper
INSEAD Working Paper 2013/44/MKT

Why do people fail to diversify risk in their retirement plans? In four studies, we show that providing information on covariance between assets, in the form of past or expected returns, may have undesirable consequences on lay investors’ allocation decisions. Indeed, lay investors erroneously believe that assets that behave differently than (i.e., are negatively correlated with) referent assets would add risk to their allocation. They tend to overweight positively correlated assets and to underweight negatively correlated assets, thus paradoxically increasing portfolio risk while trying to minimize it. Conversely, encouraging risk-taking increases the allocation in assets negatively correlated with referent assets, which may ironically reduce risk exposure. We show that this diversification bias is deliberate and cognitively effortful, and suggest ways to improve investment decisions and financial education.