Portfolio Choice and Perceived Diversification†

The old adage about putting all of one’s 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.