Naïve Diversification

NAME OF HEURISTIC: Naïve Diversification | Definition | In terms of finance, it means to invest in a variety of asserts in order to reduce risk. This is an example of heuristic choice. | 1. Experimental example ORExample of how we use this heuristic in everyday life | Experiment is conducted onHalloween night. The “subjects” in the experiment were young trick-or-treaters. (a) sequential choice: In one condition the children approached two adjacent houses and were offered a choice between two candies (Three Musketeers and Milky Way) at each house. (b) Simultaneous choice: In the other condition they approached a single house where they were asked to “choose whichever two candy bars you like.” Large piles of both candies were displayed to assure that the children would not think it was rude to take two of the same. The results showed a strong diversification bias in the simultaneous choice condition: every child selected one of each candy. In contrast, only 48 percent of the children in the sequential choicecondition picked different candies. This result isstriking 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. | 2. Example of how we use this heuristic in everyday life | Graham Loomes (1991) finds evidence consistentwith the diversification heuristic. He offers subjects a seriesof gambles with three possible states of the world A, B, andC where pr(A) > pr(B) > pr(C). If state C occurs thesubject wins nothing. The subject can divide £20 between Aand B, winning the amount placed on a state if that stateoccurs. Rational subjects would put all the money on A,thereby maximizing the expected payoff, but very few subjects did this. Instead, most divided the £20 in proportion topr(A)/pr(B). |

Sources: http://faculty.chicagobooth.edu/richard.thaler/research/pdf/DiversificationStrategies.pdf