Portfolio Choice and Perceived Diversification

David Rode Department of Social and Decision Sciences Carnegie Mellon University May 25, 2000

The old adage about putting all of ones eggs in one basket was thought wise long before the advent of modern portfolio theory and the important results of Markowitz (1959) and others. However, despite the anecdotal imperative to investors to diversify their portfolios, the empirical reality is that diversification rarely takes place as recommended by portfolio theory. In this paper, I demonstrate that psychological influences and well-known cognitive biases from the behavioral decision-making literature could cause investors to make portfolio decisions differently than suggested by normative models. Investors are shown to be modeled more accurately by prospect theory. At the same time, under practical constraints on the environment facing most investors, their heuristics allow them to achieve performance comparable with normatively-allocated portfolios. Thus, advice given to investors should focus on the consistent and careful application of simpler heuristic approaches, rather than on more complex normative portfolio-selection models.

Thanks go to my committee members, Paul Fischbeck, John Miller, and Baruch Fischhoff, for their help with this project and to Carter Butts, Andy Parker, Michele DiPietro, George Loewenstein, and Steven Klepper for many thoughtful discussions. I would also like to thank the members of the Carmel Hadassah Investment Club, the CCC Investment Club, Women Investing Now, and the Ladies of the Court. Special notes of thanks go to Ruth Silverman, Sally Sleeper, Marilyn Sleeper, Sue Rode, Carol Anderson, and Eileen Boerio for their help in coordinating the investment clubs participation. Of course, the usual disclaimer applies.

I. THE EXHORTATION TO DIVERSIFY

The sense that diversifying assets is a good idea was merely well-reasoned speculation until the appearance of Markowitzs (1952, 1959) mathematical demonstration of its risk-reducing power. In the Markowitz framework, investors measure the riskiness of investments by their return variance in the context of a portfolio, or collection of assets. When risky assets are aggregated, it is their covariance that often determines the majority of the total risk, rather than only their variance. Consequently, Markowitz demonstrated that the total risk of a portfolio could often be less than the sum of the portfolios component pieces. As a result, financial theory began to concern itself with systematic risks, as opposed to the idiosyncratic risks of earlier work in investment analysis. At least for the last decade, investment advisors have consistently touted the advantages of diversification to individual and institutional investors alike (e.g., Peavy and Vaughn-Rauscher, 1994; Wasik, 1995; Anderson, 1998; Hays, 1998; Hulbert, 1998; Spragins, 1999). And, at least since Evans and Archers (1968) classic work on diversification, investors have appeared to accept the advice on holding a diversified portfolio. In pursuit of proper implementation, however, numerous obstacles appeared. There was far less consensus on exactly what constituted a properly diversified portfolio; the gap between dont put all your eggs in one basket and Markowitzs algorithm was substantial.1

1Evans and Archers (1968) pioneering work showed that nearly all of the diversifiable risk is eliminated in

a portfolio of ten securities. Naturally, this depends on what is assumed to be the set of all possible securities. Evens and Archer (1968) looked solely at domestic stocks. Statman (1987) claimed that the benefits of diversification were essentially exhausted after 30 securities. Sears and Trennepohl (1993) and Bodie, Kane, and Marcus (1993) appear to suggest that the correct number is somewhere between the previous limits. Antanasov (1998) claims that investors can achieve a good level of diversification by holding six to ten mutual funds, but that more than ten isnt necessary. Wasik (1995) reports that the National Association of Investment Clubs (NAIC) advocates the Rule of 5 - holding no fewer than 5 stocks. It is worth noting that the NAICs justification for this heuristic is that of the five stocks, one will probably be a loser, three will produce mediocre results, but the fifth will be a real winner. (Shefrin, 2000) Further, NAIC Board of Trustees president and CEO Kenneth Janke (1994) wrote that there was no magic formula for diversification. At the very least, this evidence suggests the potentially dangerous inadequacy of simple heuristics. At the worst, it suggests that investment experts are propagating irrational advice on asset allocation (Canner, Mankiw, and Weil, 1997). However, as Elton and Gruber (2000) note, correcting Canner et al. (1997), expert portfolio allocation recommendations cannot necessarily be declared irrational simply because they disagree with one another. The myriad of different portfolios observed result from the experts making significantly different assumptions about the inputs and using different sources of data. This diversity of strategy only exacerbates the complexity of the problem facing investors.

It may be the case that investors understand - in general terms - the importance of diversification, but fail to implement it properly. For example, Benartzi and Thaler (1998) note that retirement-fund allocations tend to follow a 1/n rule. Assets are split evenly between the number of available options, regardless of what those options might be. Later we claim that using heuristic rules can be prudent for investors, though Benartzi and Thalers (1998) work demonstrates the potential danger in the misuse of such simple rules (e.g., put a little bit in everything). Alternatively, it may be the case that the diversification investors actually desire is not the diversification that Markowitz (1959) wrote about. Investors may find Markowitz diversification unpalatable (Fisher and Statman, 1997). Even when it comes to professional investors, the evidence is mixed. Michaud (page 33, 1989) provides anecdotal evidence that a number of experienced investment professionals have experimented with mean-variance [MV] optimizers only to abandon the effort when they found their MV-optimized portfolios to be nonintuitive and without obvious investment value . . . . (T)he optimized portfolios were often found to be unmarketable either internally or externally. In fact, in several cases, there is explicit evidence against proper diversification. Money (1998) asked six prominent economists for their TIAA-CREF asset allocations. Not one indicated having anything even close to Markowitz diversification - not even Harry Markowitz himself. In fact, Markowitzs comments on the subject are quite insightful (page 118, Money, 1998): I should have computed the historical covariances of the asset classes and drawn an efficient frontier. Instead, I visualized my grief if the stock market went way up and I wasnt in it - or if it went way down and I was completely in it. My intention was to minimize my future regret [emphasis added]. So I split my contributions fiftyfifty between bonds and equities. Several of the comments include direct acknowledgement of non-Markowitz allocations. Of course, caution must be exercised in interpreting these results. Most respondents had significant holdings outside of their TIAA-CREF accounts. Thus, only a fraction of their total wealth was measured. The enduring discrepancy between intent and implementation is striking. Markowitz diversification has only rarely been observed among investors (Blume and Friend, 1975; King and Leape, 1984). And yet, the need for diversification ranked second (43.6% of responses) in a list of 34 variables in a survey of 137 shareholders (Nagy and Obenberger, 1994). Interestingly enough, the desire to minimize risk ranked ninth (32.3% of responses). Perhaps the most interesting result

being that the need for diversification is seen as different from risk minimization. One gets the sense that investors know that diversification is a good thing, but are not sure exactly why. To be sure, investor psychology is not the only influence on diversifying practice. Several other reasons (described in Table 1) have been advanced as explanations for the observed behavior of investors. Still, these reasons are unable to explain entirely the degree of divergence of empirical reality from theory. More importantly for our purposes, the various structural and institutional factors addressed by the literature contribute to the complex decision-making environment faced by individual investors. The complexity that they add to the theoretical, highly-abstracted portfolioselection problem contributes directly to the biases observed in investor behavior and the cognitive complexity so daunting to investors. Although investment advisors almost unanimously advocate diversification, the advice on implementation represents a cacophony of disparate rules, many in conflict with the driving principles of Markowitz efficiency. The lack of clear and consistent advice to investors results in haphazard response to asset allocation above and beyond that which can be explained by transaction costs and institutional restrictions. Investors find it difficult to understand what it is about diversification that makes it so valuable. As a result, they resort to heuristic approaches that more often than not address the perception of diversification, rather than the reality. I propose to elicit preferences for diversifying behavior from investors in an attempt to understand the particular attributes of normative portfolio choice that appear unsatisfying to most investors. In addition, by using well-known results in the behavioral decision-making literature, I will explore the attractiveness and performance of alternative portfolio-selection rules. The consistent application of certain classes of these rules may produce results sufficiently close to mean-variance efficiency so as to serve as reasonable, but simpler, substitutes for many investors.

Table 1: Commonly Suggested Reasons for Improper Diversification Demographics/Life-Cycle Constraints (Hanna and Chen, 1995) Passive Rebalancing (Arnott and Lovell, 1993) Institutional and Data Restrictions (Bawa, Brown, and Klein, 1979; Sutcliffe and Board, 1988) Global Convergence (Errunza, Hogan, and Hung, 1999) Transaction Costs (Brennan, 1975; Keim and Madhavan, 1995; 1996) Non-Markowitz Preferences (Baker and Haslem, 1973; Kraus and Litzenberger, 1976) As investors age, they face consumption and investment constraints to their portfolio structure not considered by mean-variance analysis. Investors neglect changes to portfolio weights for which they are not directly responsible. Asset divisibility and market depth limitations may limit the ability of investors to take the positions indicated by Markowitz diversification. Achieving proper diversification is becoming more difficult to achieve because international asset returns are becoming increasingly intercorrelated. The presence of transaction costs increases the marginal cost of diversification. These costs include not only the institutional costs, but also market impact costs and informational costs. Investors may have explicit preferences opposing mean-variance efficiency, though still utility-based.

II. COGNITIVE AND BEHAVIORAL INFLUENCES ON PORTFOLIO CHOICE

The very meaning of well-diversified is not shared between researchers and practitioners. Even among investors aware of the Markowitz paradigm, mean-variance efficiency is seen as different from well-diversified. More to the point, a common reaction is to find Markowitz diversification suspicious (Green and Hollifield, 1992), unmarketable (Michaud, 1989), or, in Fisher and Statmans (1997) particularly apt term, unpalatable. The theoretical advantages of Markowitz diversification are clear; what remains unclear is the source and nature of investor aversion to it. Examining such behavior would seem to be the first step towards either attempting to educate investors on prudent diversification or constructing a new theory of portfolio choice in greater consonance with empirical reality and the expressed preferences of investors. I have divided the influence of behavior on this problem into two areas: intent and implementation. By intent, I mean that investors may deliberately and knowingly choose to diversify in a manner inconsistent with Markowitz (1959). Implicit in such an action may be the recognition that Markowitzs algorithm does not minimize the risk as perceived by investors; that variance is an inadequate measure of investment risk. By implementation, I mean that investors, while intending to

implement the correct algorithm, make mistakes or face cognitive constraints on their ability to confront complex investment problems requiring the use of heuristic approaches. To analyze the role of behavior in portfolio choice, I ran several experiments designed to explore the reaction of investors to diversifiable risks. Two groups of subjects were used to examine different populations. The first group consisted of 35 members from four amateur investment clubs. The clubs had been in existence for approximately 4 years, had 10 members on average, and had between $15,000 and $150,000 invested. Unintentionally, all 35 investment club members were women. Investment club members were used as representative not of the average population, but of the average population with an active interest in learning about investing. This was ostensibly the reason investment club members were used by DeBondt (1998) as well. Other researchers have used long-standing customers of major brokerage houses (e.g., Lease, Lewellen, and Schlarbaum, 1974), but at the time those studies were conducted, that group represented a rarified stratum of the general population. The second group in this study consisted of 107 students in an undergraduate decision analysis class. The most significant differences between the groups for this research is the fact that although the students are more quantitatively inclined than the club members, most have no actual investing experience. Intent and the Perception of Risk Markowitz (1959) and others felt that investors should minimize portfolio variance because researchers felt that investment risk was best (of the feasible measures at the time) represented by statistical variability at the portfolio level. Statistical variability, however, may not be the measure used, at least implicitly, by most investors.2 In fact, several researchers have found evidence to the contrary. Gooding (1975) examined the preferences of investment professors, portfolio managers, and individual investors and found significant differences between the groups in the dimensions used to evaluate stocks. In general, portfolio managers and investment professors used price-toearnings ratios and downside risk (semivariance), while individual investors used dividend yields, past returns from holding the stock, and past growth. Although downside risk comes close, none of the evaluation dimensions involves variance or any portfolio-level risk measures at all. Watts and Tobin (1967) surveyed 4,000 households attempting to explain a variety of diverse asset holdings

2To be fair, Markowitz (1959) and Sharpe (1964) both refer to other measures, such as semivariance, as

possibly being more descriptively accurate.

(from furniture to installment debt). Although a number of the variables were statistically significant, none of the models were able to explain more than 5% of the variance in any of the asset categories. These findings suggest that there is no clear, simple measure of investment risk as perceived by investors. Many individual investors, as a heuristic strategy, look at time-series graphs of asset prices to judge how risky a particular asset is (e.g., Gooding (1975) reports this behavior, and it was also found among the investment club members questioned in this paper). In so doing, however, they make themselves subject to a variety of biases concerning how such information is displayed. For example, time series generally present price data, but risk is measured in terms of return data. Visually converting a price time series into a return time series is likely to be nontrivial for investors, even if investors could then calculate variances. Loewenstein and Prelec (1993) note that people have preferences for increasing sequences of outcomes (consumption paths in their work) and against decreasing sequences. In addition, Baker and Haslem (1973, 1974) noted that investors have strong preferences for stability (of earnings, of price, of dividends, etc.). To explore these issues, the decision analysis students were given combinations of graphs and asked to indicate whether they represented equally risky investments or if one or the other was riskier. For a comparison between two graphs with equal return variances (that theory would then conclude were equally risky), only 18% of the subjects said they were equally risky. The remaining subjects were split equally as to which of the two graphs represented the riskier investment.3 The difference between the number who indicated equivalence and the other subjects was statistically significant (p < 0.001). The differences were more pronounced when subjects were given the two series displayed in Figure 1. The smooth decreasing series has a lower return variance than the saw-toothed series, although both have equal price variances. In this case, only 17% of the subjects indicated that the series were equally risky. Financial theory would indicate that the saw-toothed series, which had a greater variance, was riskier. However, more subjects (51% to 32%) chose the smooth decreasing series as riskier (p < 0.05). Thus, although this heuristic may have some value in drawing broad

3Half indicated that the increasing series was riskier and half indicated that the decreasing series was riskier.

The increasing series had a greater price variance, but both had equal return variances.

distinctions between different risk levels, it can also lead investors astray by preying on their biases for directions in sequences and misperceptions of risk and stability.
Figure 1: Stable versus Unstable Sequences and Judgments of Riskiness The saw-toothed series has a greater return variance, but price variances are equal Index Value 140 120 100 80 60 40 20 20 40 60 80 100 Days Index Value 140 120 100 80 60 40 20 20 40 60 80 100 Days

In general, the statistical variability of the assets may, in fact, have very little bearing on investors perceptions of total risk. In this sense, asset variance may be only one element of a larger risk construct, to use Yates and Stones (1992) term. De Bondt (1993) notes that perceived risk depends on prior performance in forecasting risk and return and that risk premia change because risk perceptions change, not because of changes in the publics willingness to bear risk, or because objectively the stock became more risky. As Fischhoff (1985) notes, people disagree more about what risk is than about how large it is. In practice, and especially for those investors without significant statistical training, the concept of risk may be more of a visceral state than an affectually cold number. Yet, the standard theories of investment selection completely ignore hedonic responses. If, as investors appear to be doing, we are to view risk through more than the narrow window of statistical variation, if we are to consider the risk experience, we are led back to our initial question: to minimize risk, what should investors do (if not minimize portfolio variance)? Before considering the answer to that question, an important related question involves what investors actually do and think. Perhaps, investors perceptions, though different on the surface from normative thinking, allow them to respond in near-normative fashion. The investment club members studied for this paper clearly claim to value diversification. When they were asked how

important holding a diversified portfolio was to them, their median response was 5 on a scale from 1 (not very important) to 7 (extremely important). Subjects also tended to feel that their portfolios were diversified. When asked how diversified they considered their own assets, the median response was also 5 on a scale from 1 (not very diversified) to 7 (extremely diversified). These responses were correlated at 0.57 (p < 0.001). Despite these claims, subjects responses to several questions suggest that investors fail to recognize core portions of portfolio theory. For example, when asked whether or not the risk of a stock depends on whether its price typically moves with or against the market, 25 subjects disagreed, while only 8 agreed (p < 0.05). This is a clear rejection of the notion that covariation determines risk. Nagy and Obenbergers (1994) results suggest that investors perceive diversification as a separate activity from portfolio risk management. Instead, my results would suggest that investors do see diversification as related to risk management, but that risk represents a much broader notion of uncertainty than mere statistical variability. Thus, Nagy and Obenbergers (1994) results actually indicate that investors see diversification as at least a partially separate activity from portfolio statistical risk management, though not necessarily from total perceived risk management. In attempting to incorporate a broader definition, however, investors become subject to several classical biases commonly observed in the behavioral decision-making literature. I identify three primary biases: availability, illusion of control (Langer, 1975), and lack of portfolio thinking.4 The following three questions illustrate these biases: Availability: Owning stock in local companies or in companies whose products I like and use is a good idea. 24 Agree Illusion of Control: In my stock portfolio, I would rather have just a few companies that I know well, rather than many companies I know little about. 28 Agree 7 Disagree (p < 0.05) 11 Disagree (p < 0.05)

4I use the term lack of portfolio thinking deliberately to be suggestive of the lack of systems thinking

first described by Fischhoff et al. (1978).

Lack of Portfolio Thinking: Which of the following choices best describes your definition of diversification? Large number of assets Equally-sized holdings of assets Firms in different industries Firms performing differently in the past Other (free response): real estate, firms of different sizes 2 0 29 2 2

In each case, subjects chose differently than financial theory would suggest. Imposing limitations on portfolio structure based on location falls outside of Markowitz diversification. In fact, a case can even be made for underweighting such investments, which are likely to be correlated with local real estate values and the local market for human capital. The perception that control reduces risk is common. Whether investors are simply overconfident in their abilities or fail to acknowledge market efficiency, the desire for control is clear (DeBondt, 1998). The case for lack of portfolio thinking seems clear given the overwhelming response to the wrong answer (investors should be looking at past performance to estimate correlation). However, it may be that investors are attempting to use industry stratification as a proxy for estimating future beliefs about the correlation structure between securities. If so, this would be consistent with the heuristic first suggested by Elton, Gruber, and Padberg (1976, 1977) as a simpler means of implementing mean-variance efficiency. The evidence presented here suggests that investors do intend to diversify, but are limited in their ability to diversify properly by their dependence on informal and broad conceptualizations of risk. These heuristic approaches to risk estimation (whether visually inferring risk from time series or using control-based proxies such as firm location) subject them to biases that cause their responses to deviate from those considered optimal in financial theory. Manipulation of Preferences and the Implementation of Portfolio Selection Rules Even if we assume that investors intentionally pursue mean-variance efficient portfolios in the name of risk reduction, we still must face the substantial possibility that they make errors in accomplishing this task. Two frequently-advanced counterarguments to this claim should be addressed:

(1) (2)

The investors that matter are experts, and they have good models and fast computers, so they dont make mistakes. Professional investors are well-trained in their tasks and would never succumb to such biases in judgment or choice.

These two objections fail to understand fully the nature of the implementation errors that we are concerned with here. More importantly, despite their face validity, they are frequently and demonstrably false. Poulton (1994) reviews a number of experiments demonstrating, for a broad range of activities, that while experts generally perform better than laypersons at various judgment and choice tasks, they still make mistakes with significant regularity. Implementation errors can take numerous forms. Slovic (1972) suggested that even financial experts are unable to use their models correctly and consistently. Elton, Gruber, and Padberg (1976, 1977) indicated that multicriterion decision making concerning portfolios was cognitively taxing and thus, prone to error. Kroll, Levy, and Rapoport (1988) demonstrated that, even with practice, investors exhibited high rates of requests for useless information, frequent (and thus overly costly) switching between assets, and sequential dependencies (gamblers fallacies) in an experimental investment simulation. DeBondt (1998) surveyed experienced investors and showed that most failed to use basic principles of good investing despite years of experience. By the same token, it may be the case that investors fail to grasp the theoretical intricacies of Markowitz diversification, but still manage to attain levels of mean-variance efficiency close to optimal. Thus, the question of response to diversification must be treated separately from recognition of diversification. To examine investor response, I used a simple coin-toss experiment. Subjects were asked how many coins they would toss when faced with the following payoff schedule: Small Payoff Toss 1 coin, if heads, you get $16 Toss 2 coins, earn $8 for each heads Toss 4 coins, earn $4 for each heads Toss 8 coins, earn $2 for each heads Toss 16 coins, earn $1 for each heads Large Payoff ($1,600) ($800) ($400) ($200) ($100)

Clearly, the expected values are all equal, but the variance of the gamble decreases as the number of coins increases. Presumably, if subjects recognized the benefits of diversification (a reduction in variance by spreading risks), they would choose to toss more coins (particularly in the large payoff condition) regardless of whether or not they understood how the Markowitz algorithm worked. 10

Table 2 presents the results from both the investment club members and the decision analysis students. Although the difference between the large and small payoff conditions isnt
2 2 significant for the club members ( , p < 0.176), it is for the decision analysis students ( , p <

0.005). Further, for large payoffs, the students and the club members are significantly different ( 2 , p < 0.01). As expected, more coins are preferred to fewer by students in the large payoff condition (p < 0.003). Club members, however, did not exhibit this pattern (p < 0.9). In fact, for the club members, the correlation between the stated importance of diversification and the number of coins tossed was 0 for the small payoffs and negative (r = -0.36, p < 0.066) for the large payoffs.
Table 2: Coin-Toss Experiment Results Investment Club Small Payoff 1 or 2 coins 8 or 16 coins 4 8 Large Payoff 10 7 Decision Analysis Students Small Payoff 21 22 Large Payoff 10 38

With the exception of the club members in the large payoff condition, the observed behavior appears consistent with proper diversification. However, it may also be consistent with other, simpler rules such as buy a lot of things and the spreading that Benartzi and Thaler (1998) describe. That possibility appears unlikely given the earlier results that only 2 of the 35 club members said that diversification meant, to them, holding a large number of securities. One other possibility is that the club members are exhibiting risk-seeking behavior in the large payoff condition. This also appears unlikely given that their responses to other gambles (discussed in Section III) are generally not consistent with risk-seeking utility functions. Thus, it appears that investors can sometimes implement and respond to diversification opportunities, even if they do not recognize them. This evidence is not overwhelming though, and the behavior of the club members in the large condition remains difficult to explain. In addition, these gambles represent highly abstracted situations and may be perceived differently than similar decisions in an investing context. It remains an open question how the addition of investment context would impact the choices made. For example, if the subjects use industry membership as a proxy by which to implement diversification (as 29 out of 35 of the club members indicated), they would not necessarily diversify in the coin-toss experiment as that information that context was unavailable to them. Likewise, the more quantitatively-inclined 11

students may appear to perform well in abstracted situations like this gamble, but might behave quite differently in a more realistic setting. In summary, the heuristics used by investors, although frequently allowing them to implement Markowitz-like strategies, often lead them astray. These heuristics subject them to classic biases such as availability. Further, investors more expansive definitions of risk lead them to the use of heuristics based on the illusion of control and perceptions typical of a lack of portfolio thinking. As with many heuristic strategies, there are significant negative consequences for decision-makers. In order to address this behavior it is important to place it in a theoretical framework for analysis. Fortunately, the next section demonstrates the use of prospect theory (Kahneman and Tversky, 1979) for just that purpose.

III. PROSPECT THEORY AND PORTFOLIO CHOICE

For those investors who are not expected utility maximizers and who appear subject to biases commonly found in the behavioral decision-making literature, we might assume that their behavior is better described by Kahneman and Tverskys (1979) prospect theory.5 Prospect theory provides a descriptive model of risky decision making. A prospect is a collection of payoffprobability pairs (x, p) constituting a discrete probability density function for a risky choice. For our present purposes, we shall capture the two primary parts of prospect theory: [1] the decision weighting function and [2] the value function. Just as expected utility theory measures the utility of a set of outcomes as the product of probabilities and final wealth utilities, prospect theory measures the prospect value V [3] of a set of outcomes as the product of their decision weights and gain or loss values. The decision weights adjust probabilities to account for the observed tendency
5And, in fact, this appears to be the case with the investment club members. The subjects were given four

questions taken from the original prospect theory paper (Kahneman and Tversky, 1979) to illustrate their consistency with prospect-theoretic decision making. Their responses (CLUB) were consistent with those obtained by Kahneman and Tversky (K&T). For each of the four prospect comparisons, the percentage of subjects choosing A for each group is given. In none of the cases could the null hypothesis of equal proportions be rejected. A: A: A: A: (4,000, (4,000, (6,000, (6,000, 0.80) 0.20) 0.45) 0.001) B: B: B: B: 3,000 (3,000, 0.25) (3,000, 0.90) (3,000, 0.002) CLUB: CLUB: CLUB: CLUB: 26% 58% 21% 63% K&T: K&T: K&T: K&T: 20% 65% 14% 73%

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of individuals to overweight small probabilities and underweight large probabilities. Accordingly, Kahneman and Tversky (1979) proposed a decision weighting function p that was subadditive. That is, for probabilities p and q where p + q = 1 , the corresponding decision weighting function would indicate that p + q < 1 . In addition, prospect theorys value function takes into account the tendency for individuals to care more about losses than gains. Thus, the value function disproportionately weights losses more heavily than gains. A significant difference between expected utility theory and prospect theory is that prospect values are defined on gains and losses (from some reference point) and expected utilities are defined on final wealth levels. Although Kahneman and Tverskys (1979) original work did not specify functional forms for the components of prospect theory, their subsequent work (Tversky and Kahneman, 1992) estimated both the functional forms and the parameters, 6 and it is those characteristics that we shall use in this paper. Figure 2 illustrates the decision weighting function and the value function.

p =

1 /

p + 1 p

[1]

: x = x$0 x = ; = x x < 0 < V = 3 p i xi

i

[2]

[3]

6The parameters used are = = 0. 88, and = 2. 25. In the decision-weighting function, is assumed to be

0.61 for gains and 0.69 for losses. and control the curvature of the value function, controls the degree of loss aversion present ( = 1 would indicate symmetric treatment of losses), and controls the curvature of the decisionweighting function ( = 1 represents a standard probability).

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Figure 2: Prospect Theorys Decision Weighting Function and Value Function The dashed line in the decision weighting function represents a perfectly calibrated decision weight, linear between the endpoints of 0 and 1. Decision Weight 1 0.8 0.6 0.4 0.2 0.2 0.4 0.6 0.8 1 Probability Value 10 -20 -10 -10 -20 -30 10 20 Gain or Loss

Under prospect theory, a portfolio can be represented as a discretized version of its PDF. For example, we might approximate a normally distributed return with a mean of 10% and standard deviation of 20% as the prospect {{-20%, 0.25}, {10%, 0.5}, {40%, 0.25}}. Obviously, the approximation can be made arbitrarily close to the continuous form by adding branches. Standard prospect theory cannot accommodate continuous prospects, but such a level of detail is not needed for the current analysis.7 In terms of portfolio selection, the two important consequences of a prospect-theoretic decision rule involve the overweighting of small probability events and the loss aversion resulting from the antisymmetric value function. These differences from expected utility theory (Markowitz diversification is utility-maximizing for quadratic utility or normally-distributed asset returns) result in different rankings of portfolios. To rank portfolios under expected utility theory, we will use the Sharpe ratio of excess return per unit of risk (Sharpe, 1966). The portfolio with the maximum Sharpe ratio is Markowitz efficient and all Markowitz (i.e., frontier) portfolios have greater Sharpe ratios than non-Markowitz portfolios. Thus, ranking portfolios according to their Sharpe ratios represents a rule that rational decision-makers could use. The use of the Sharpe ratio, however, provides investors with two paths to efficiency: increasing return while holding risk constant or decreasing variance while holding return constant. Although both of these path frames end at the same optimal location, they are differentially attractive to different groups. Expected utility maximizers will always prefer the increasing-return path
7 Prospect theory has been extended by Tversky and Kahneman (1992) to accommodate continuous

prospects, but the additional complexity required for doing so is not justified by the minimal improvement found in the present application.

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(increasing-return portfolios second-order stochastically dominate decreasing-variance portfolios). Prospect theory decision-makers react differently depending on whether or not events are framed as gains or losses. Here, the increasing-return path represents gains and the decreasing-variance path losses. Thus, prospect-theoretic decision makers will generally prefer the decreasingvariance path (as a consequence of loss aversion). To examine these decision rules, both subject groups were split into two subgroups each and presented with three assets, represented by the payoff profiles below (Table 3) and described in Table 4. Half of the subjects (N = 17 club members, N = 45 students) were given three assets and told that they had to eliminate one (their retirement plan was cutting expenses). The other half of the subjects (N = 16 club members, N = 51 students) were given a list of the three assets and told that they had to construct a portfolio (with equal weights) out of them. They could buy one, two, or all three securities. The three assets had the same expected returns, but different standard deviations.
Table 3: Three Assets in Prospect Theory Notation Asset 1 Probability 10% chance 5% chance 85% chance Return 5% return 4% return 3.3% return Asset 2 Probability 10% chance 80% chance 10% chance Return 16% return 3% return -5% return Asset 3 Probability 10% chance 50% chance 40% chance Return 40% return 3% return -5% return

Table 4: Three-Asset Summary Statistics for Expected Utility and Prospect Theory Expected Return 3.50% 3.50% 3.50% 3.50% 3.50% 3.50% 3.50% Standard Deviation 0.52% 4.80% 12.70% 2.40% 6.40% 6.80% 4.50% Sharpe Ratio 6.73 0.73 0.28 1.45 0.55 0.51 0.77 Sharpe Rank 1 4 7 2 5 6 3 Prospective Value 0.0536 0.0375 0.0393 0.0695 0.0869 0.0824 0.1308 Prospective Value Rank 5 7 6 4 2 3 1

Portfolio 1 2 3 1&2 1&3 2&3 1&2&3

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In the asset elimination task, utility-maximizing investors could actually reach a more attractive position by eliminating Asset 3 (i.e., moving from {123} to {12}). By eliminating Asset 3, the Sharpe ratio of their portfolio would increase from 0.77 to 1.45. Prospect theory investors would prefer to eliminate Asset 2 (i.e., moving from {123} to {13}). However, they would actually prefer not to change at all, since their prospective value drops from 0.1308 to 0.0869. In the experiment, however, subjects were not given the option of remaining at the status quo. Subjects were told to select the asset they would least mind being eliminated. Table 5 presents the data for the elimination condition and Table 6 presents the data from the building condition. For the portfolio-construction task, by examining Table 4, we can see that utility maximizers would most prefer to hold their entire portfolio in a single asset (Asset 1). Asset 1s Sharpe ratio is higher than any of the other assets available, so an investors entire portfolio would be concentrated in that single asset. Should an investor then wish to achieve a different risk level, an adjustment could be made by taking a (positive or negative) position in the riskless asset. On the contrary, prospect theory investors would most prefer to add all three assets to their portfolio, as the portfolio of all three assets results in the highest prospective value. The correlation between the expected utility and prospect theory rankings was 0.071.
Table 5: Choice Frequencies in the Elimination Condition Students (n = 45) 8 12 25 Investment Clubs (n = 17) 3 6 8 Expected Utility Ranking 3 2 1 Prospect Theory Ranking 2 1 3

Elimination 1 2 3

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Table 6: Choice Frequencies in the Building Condition Students (n = 51) 13 7 4 9 8 1 9 Investment Clubs (n = 16) 1 0 1 2 2 0 10 Expected Utility Ranking 1 4 7 2 5 6 3 Prospect Theory Ranking 5 7 6 4 2 3 1

Building 1 2 3 12 13 23 123

Although the small number of data points in the elimination condition makes it difficult to analyze, it is clear that both the student and club members rankings are identical. In addition, they both clearly correspond to the expected utility rankings. In this experiment, the unattractiveness of Asset 3 stemmed from the fact that it had a much larger probability of earning a negative return than either of the other two assets. Similarly, the popularity of Asset 1 is likely a consequence of its strictly positive returns. Different results for the club members are observed in the build condition. Using the ranked data, we can evaluate the alignment of subjects choices with the two decision rules by examining their rank correlations. Table 7 presents such information. The three shaded cells are particularly important. First, we can see that the two subject groups have begun to diverge in their responses. Although they responded identically in the elimination condition, their rankings only correlated at the 0.581 level in the building condition. In addition, the decision analysis students rankings were far more consistent with expected utility theory, while the investment club members rankings were more consistent with prospect theory. However, the fact that there is but a single ranking produced for each group precludes us from testing the significance of those correlations. Instead, we shall explore several other analyses and show that the use of prospect theory as a model of amateur investor behavior is supported, at least in part, by each of them. These results are consistent with Olsens (1997) findings that professional investors behavior is also consistent with prospect theory.

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Table 7: Correlations Between Subject Group and Normative Rankings Decision Analysis Students Decision Analysis Students Investment Club Members Expected Utility Ranking Prospect Theory Ranking 1.000 0.581 0.920 0.198 1.000 0.344 0.707 1.000 0.071 1.000 Investment Club Members Expected Utility Ranking Prospect Theory Ranking

For all individuals in both groups and both rules, we will replace the indicated portfolio choice with the rank of that choice under either expected utility theory or prospect theory (from Table 6). To the extent that a groups decisions are more consistent with one rule than another, the mean rank of its individuals portfolios should be lower when coded according to that rules ranked values. Mean ranks closer to one indicate increasing alignment with the coding rule used (expected utility theory or prospect theory). Thus, by comparing the mean ranks of the two groups, we can ascertain which rule provides a better model of the subjects portfolio-selection behavior. The students choices had an average rank of 3.14 when ranked by expected utility and 3.96 when ranked by prospect theory. The investment club members choices had an average rank of 3.25 when ranked by expected utility and 2.06 when ranked by prospect theory. These differences were significant in the hypothesized direction. The students used expected utility theory (3.14 < 3.96, p = 0.018 by the Mann-Whitney test) and the club members used prospect theory (2.06 < 3.25, p = 0.007 by the Mann-Whitney test). One possible explanation for this result involves the relatively abstracted nature of the experiment and the more quantitative nature of the decision analysis students. At least in theory, the decision analysis students are familiar with expected utility theory and should be able to solve the problem correctly. The investment club members, although having more practical experience, are less problem-solving inclined and thus, more likely to fall prey to the biases behind prospect theory. One possible question on implementation concerns the use of ranks imputed from the frequency data. Since ranks are not actually elicited from the subjects, there is some cause for 18

concern that each subjects own ranking could be different than the imputed consensus rank. To address this concern, assume that each subject has an internal ranking of the seven possible portfolios in accordance with a decision rule. Although subjects intend to implement their internal rankings (by selecting as their most preferred alternative the highest internally-ranked alternative), suppose that there exists some probability of error (as a result of miscalculation, for example). I will assume that any such errors could extend only three levels deep. This means that any differences between indicated ranks and the theoretical rankings greater than three levels would not be attributed to implementation error. In addition, the greater the difference, the less likely it is attributable to implementation error (and the more likely it is because some alternative rule is used). There are 5,040 possible ways to rank 7 choices (ties excluded). By assigning these weighted ranking scores to all possible choices, we can examine the number of different rankings (decision rules) which could be more preferred to the hypothesized choices. Using this method, no decision rule results in a higher rank score for the decision analysis students than expected utility theory (i.e., the three highest frequency choices were those ranked 1, 2, and 3 by expected utility theory). By comparison, prospect theorys rank score for the students placed it 4,594th. Similarly, for the investment club members, no decision rule results in a higher rank score than prospect theory. By comparison, expected utilitys rank score for the club members placed it 1,321st. To clarify this point, although there are several different rankings which have equal scores (expected utility tied with 23 others for the students and prospect theory tied with 119 others for the club members), none exceed these values. Thus, although we may be reasonably certain of the rankings elicited, attributing them to a particular theory is less certain. For example, the prospect theory rankings are identical to the rankings of a person who wished only to rank more highly those portfolios containing larger numbers of securities. This problem in judging the classification of portfolio choices is well known (Elton and Gruber, 2000). The implications of this support for prospect theory as an accurate model of actual investor behavior are significant. One example suggested previously addresses the framing issue for assetallocation decisions. Diversification would appear more attractive to investors when introduced in the decreasing-variance frame than in the increasing-return frame. Prospect-theoretic decisionmakers are more motivated by diversifications ability to eliminate extreme negative returns than would be expected utility decision-makers. The ability of prospect theory to explain investor

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behavior suggests that capital market theory should take notice of these results and make adjustments where required.

IV. PERFORMANCE OF PORTFOLIO SELECTION HEURISTICS8

If investor behavior is better explained by prospect theory because investors fall prey to several well-known decision-making biases and these biases cause investors to make portfolioselection decisions differently than would be advised by normative models, then it is reasonable to ask, that despite differences in implementation, are the results substantively different? That is, are investors suffering economically as a result of their biased decision making? To answer this question, a reasonable model of the investment environment must be assumed. Although Markowitz diversification allows negative asset weights and potentially extreme leverage, these are not realistic descriptions of the environment facing individual investors. Thus, we must look to constrained Markowitz optimization models as the appropriate comparison. The lure of heuristic strategies is both in their simplicity as well as in their richer treatment of risk. In this constrained environment, how much performance are investors sacrificing in order to get simplicity? In the following analysis, we shall examine the performance of several different portfolioselection heuristics suggested by cognitive biases. We shall compare their performance to the Markowitz algorithm based on their Sharpe ratios. Negative weights are prohibited 9 (since most
8The data used in this section were compiled from several sources. Most index data were obtained from CSI

Data. Currency and precious metals data were obtained from Olsen and Associates. CRB index data were obtained from CRB/Bridge Associates. Real estate investment trust (REIT) index data were obtained from the National Association of Real Estate Investment Trusts (NAREIT). The data represent daily total returns (capital appreciation and dividend or interest income) to U.S.-domiciled investors during the period January 5, 1994 to December 31, 1998 (1,259 observations). When dates did not overlap for foreign investments (because of holidays not recognized by U.S. financial markets), the asset value for the closest U.S. business day was used. Returns were calculated in the usual manner: U.S. investment, commodity, and real estate returns were calculated as rt = ln t ln t1 . Foreign currency returns used European convention and were calculated as rFC = ln S t 1 ln S t . Foreign index returns were t repatriated daily to U.S. dollars and calculated as rFM = ln t ln t1 + ln S t1 ln S t . The assets price is given t by except for foreign currencies which are valued at their spot rate S.

9As a result, strategies that call for equal investment across asset classes exclude those investments with

negative expected returns. Negative returns can only be exploited by strategies capable of taking negative weights.

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investors are substantially short-sale constrained), and the available assets are limited to the nine assets described in Table 8. The assets are representative of those most commonly available (in some form) to individual investors. The strategies to be considered are described in Table 9.
Table 8: Assets Commonly Available for Investment by Individual Investors (1994-1998) Asset Bridge/CRB Index British Pound FTSE-100 Index Gold (NY Spot) Japanese Yen NAREIT Total Return Index NASDAQ/NMS Index Nikkei 225 Index S&P 500 Index Average Return 1.77% 2.39% 13.48% -6.34% -0.39% 9.19% 20.50% -5.40% 19.39% Standard Deviation 8.16% 6.56% 15.39% 8.38% 11.51% 8.81% 17.91% 25.06% 14.45%

By comparing the Sharpe ratios of the heuristic strategies to the Markowitz algorithm, we can obtain a measure of the relative efficiency of the different strategies. If a heuristics performance is comparable to the constrained Markowitz optimum, then proper use of that heuristic represents a prudent choice on the behalf of information-constrained and cognitively-biased investors.

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Table 9: Cognitive and Behavioral Biases and Heuristic Portfolio-Selection Strategies Heuristic Strategy Positively-Weighted Markowitz Positively-Weighted Fisher-Statman Unmanaged S&P 500 Major Industry Groups 3-Asset Random Portfolio 4-Asset Random Portfolio 5-Asset Random Portfolio Green-Hollifield 10 Most Widely Held (from among all publicly-traded US stocks) 10 Largest Mutual Funds (from among all publicly-traded funds) Local (Pittsburgh) Stocks Behavior/Cognitive Bias None Simplicity Simplicity Simplicity Simplicity Simplicity Simplicity Regret Regret Illusion of Control Availability Description Markowitzs algorithm with weights constrained to be positive Minimization of the weighted variance of the assets, constrained to be positive Buy and hold the S&P 500 Index Use SIC classifications to diversify Select three assets and hold them Select four assets and hold them Select five assets and hold them Invest equally in all assets Determine the assets most commonly held by other investors and buy them Buy an equal-weighted portfolio of large mutual funds Buy stock in companies with headquarters in Pittsburgh

Fisher and Statman (1997) suggested that investors, in order to simply the decision-making process, simply ignore the off-diagonal elements of the covariance matrix. That is, they minimize weighted variance. Green and Hollifield (1992) suggested that a strategy of holding all assets in equal proportion was reasonable and easy to think about. Alternatively, other strategies popular with investors include using an index fund (the S&P 500), randomly selecting investments, buying what other people are buying (the most widely held stocks), diversifying through mutual funds, buying stock in companies that they are familiar with, and using industry membership as a simple proxy for the covariance structure of assets.10
10The ten most widely-held stocks of NAIC members at the beginning of 1994 were: McDonalds, Merck,

Pepsi, Wal-Mart, AFLAC, AT&T, Motorola, Disney, Coca-Cola, and Abbott Labs. At year-end 1999, the ten largest mutual funds were: Fidelity Magellan, Vanguard Index 500, Washington Mutual Investors, Investment Company of America, Fidelity Growth and Income, Fidelity Contrafund, American Century Ultra, Vanguard Windsor, Janus, and Vanguard Wellington. The local Pittsburgh stocks are Alcoa, Calgon Carbon, DQE, Heinz, Mellon, PPG Industries, USX, and American Eagle Outfitters. The industries (firms) are: Aerospace (Boeing), Auto (Ford), Food (Heinz), Leisure (Harley-Davidson), Paper (International Paper), Retail (Wal-Mart), Textiles (Shaw Industries), Utilities (Duke Power), Computers (IBM), and Banks (Bank of America). The riskless-rate used to calculate the Sharpe ratios is the one-year constant maturity US Treasury bond and averaged 5.495% during the period studied.

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These strategies all result in different portfolio structures. However, the performance of many of these strategies is comparable to the Markowitz optimum. Put another way, they have high efficiency relative to the Markowitz portfolios performance. Table 10 presents the performance of the heuristic strategies.
Table 10: Performance of Heuristic Portfolio-Selection Strategies Expected Return 19.39% 19.39% 19.39% 20.48% 18.33% 11.12% 19.03% 11.12% 11.20% 11.31% 14.34% Standard Deviation 14.14% 14.24% 14.45% 16.44% 15.27% 7.03% 17.13% 7.27% 7.68% 8.33% 16.66% Sharpe Ratio 0.98 0.98 0.96 0.91 0.84 0.80 0.79 0.76 0.007 0.71 0.013 0.65 0.019 0.53 Relative Efficiency 100.0% 99.6% 98.0% 92.9% 85.7% 81.6% 80.6% 77.6% 72.4% 66.3% 54.1%

Strategy Positively-Weighted Markowitz Positively-Weighted Fisher-Statman S&P 500 Index Fund 10 Most Widely Held Stocks 10 Largest in Different Industries Green-Hollifield (6 Assets) 10 Largest Mutual Funds 5-Asset Random Portfolios 4-Asset Random Portfolios 3-Asset Random Portfolios Local Pittsburgh Stocks

In this constrained environment, it may appear that investors can disregard the driving influence of Markowitz diversification: covariation. There are several heuristic approaches that come very close to constrained Markowitz efficiency. This is not so much evidence of heuristic power as the cost of imposing constraints on Markowitz. For the sake of comparison, the unconstrained Markowitz optimum has a mean return of 19.35% and a standard deviation of 10.17% (Sharpe ratio of 1.36). However, this unconstrained portfolio, apart from being difficult to implement for many individual investors, may also be unpalatable (Fisher and Statman, 1997). The unconstrained allocations require investors to sell short gold to the equivalent of half of their wealth and invest nearly 30% of their wealth in British pounds. Relaxing the other restriction (commonly-recognized assets), would also provide significant benefits. At the same time, the learning and transaction costs inherent in becoming comfortable with and investing in other, less common asset classes may far exceed their marginal contribution to the portfolio for most investors.

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The lesson in this analysis is twofold: (1) constraints on the composition of the feasible set are costly, and (2) if investors must include such constraints, there are several heuristic strategies that provide very close replication of the Markowitz portfolios performance. To answer the question posed at the beginning of this section: it does not appear that investors would necessarily suffer as a result of using heuristic strategies.

V. DEBIASING AND ADVICE GIVEN TO INVESTORS

Investors are told constantly that diversification is a good thing. Unfortunately, they are rarely consistently told what diversification means. Not only is some of the advice given to investors on diversification wrong, but the sheer diversity of the advice, which is sometimes conflicting, can often be confusing to investors. This confusion, together with the complexity of implementing Markowitz diversification leads many investors to make poor asset-allocation decisions. These poor (and costly) decisions are particularly unfortunate because careful and consistent use of many of the simple heuristics investors find appealing can lead to nearly optimal performance. The greatest benefits of Markowitz diversification generally result from taking extreme, and often negative, positions in various assets. Due to institutional and regulatory limitations, as well as capital constraints, for most investors these portfolios are infeasible. The added benefit of implementing Markowitz diversification on portfolios facing these constraints is minimal and not worth the added complexity and potential for error present in the normative diversification algorithms. In the terminology of Fischhoffs (1982) review of the debiasing literature, the portfolioselection problem is characterized by both faulty tasks and faulty judges. A long-standing problem of financial theory has been the failure to provide a satisfactory descriptive treatment of risk; the task is partially to blame. Investors are advised to minimize variance (at least implicitly, through admonitions to obey Markowitz diversification) without being informed as to why variance might be the important measure. But the judges - investors - are partially culpable as well. Had explanatory material on variance been provided, would investors understand it? There are fundamental language and knowledge barriers that most investors fail to overcome.

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But is the solution, then, to turn all investors into experts in portfolio theory? Clearly, the cost of such training rules out such an endeavor. More importantly, it is not necessary. As a consequence of the numerous divergent messages given to investors on portfolio management, there is widespread misunderstanding of the problem. However, as Fischhoff (1982) notes, one potential solution to misunderstanding is to provide an alternate goal. It is this solution that this paper has addressed. Markowitz diversification need not be the goal sought by all investors, despite its normative standing. The goal is not Markowitz diversification for its own sake, but rather the efficient management of risk. For this alternate goal, there are many paths by which to achieve it. Too often, the advice given to investors has been at one extreme (too technical: solve a quadratic program) or the other (too nave: there is no magic formula for diversification). Each approach can lead investors to make costly errors. The reality is that there are simple rules that, when applied consistently, provide investors with near-optimal performance. Thus, the important information that must be provided to investors is the reason why Markowitz diversification works: covariation. More generally, that risks must be calculated and managed at the portfolio level, rather than at the individual asset level. The experiments carried out in this paper demonstrate that investors do not make a clear connection between risk reduction and diversification; that they pursue diversification for its own sake, rather than to achieve a reduction in portfolio risk. Further, portfolio allocation decisions appear to be influenced by how those decisions are presented. All of this evidence suggests that investors are simply unable to reconcile the numerous pieces of advice that they receive on portfolio management in time sufficient to make effective decisions. Investors must often transact in an environment characterized by substantial uncertainty. Here, the pressure is on getting investors the information that they need in a form that they can quickly, correctly, and consistently interpret. As the numerical results illustrate, in a realisticallyconstrained trading environment, the consistent application of very simple strategies produce results nearly as good as the (constrained) Markowitz optimum. Advice given to investors should be built around this fact, not on the pursuit of more complicated investment management strategies.

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