“Diversification Bias: Explaining the Discrepancy in Variety Seeking Between Combined and Separated Choices” Read and Loewenstein (1995)
Although this is not a behavioural finance paper, I believe it can help explain the anomaly of investors underdiversifying their portfolios. The key finding is that participants seek a lot more variety while making simultaneous than sequential decisions. In the context of consumer decision making sequential choice actually leads to a bias. People seek more diversity than their consuming self at future points would actually desire.
From standard microeconomic theory, diminishing marginal utility is the reason to diversify consumption bundles. You might prefer 1 chocolates to 1 orange, but after consuming 5 chocolates you might now prefer an orange. Your marginal utility – the utility from consuming an extra unit – of chocolate has decreased. Diminishing marginal utility is a big factor over short timescales, but over longer timescales it’s impact is much less. If I’ve just eaten a chocolate I might prefer an orange, but if I last ate chocolate yesterday I might still prefer chocolate today.
In consumer decision making diversification bias arises when people have to make multiple purchases at one instant when the consumption is spread out over time – they go for more diversity than their future selves would prefer. The corollary of diversification bias in investing – where investors place their portfolios in too few assets – might be driven by the opposite mechanism: when investors make multiple asset allocation decisions at different time points. Framing individual investing decisions as part of a greater plan might ameliorate this bias. Two quotes from the paper point to this:
“the discrepancy in variety seeking occurs because simultaneous choices are presented together and are thus framed as a type of portfolio choice, whereas sequential choices are considered in isolation.”
“Simultaneous choices are presented to subjects in the form of a package, and perhaps the most straightforward choice heuristic applicable to such packages is diversification.”
The final experiment of this paper suggests that such a simple reframing can have an influence on choice. During Halloween children were asked to choose 2 chocolates from a tray of 3 alternatives. The manipulation was that some children made this choice simultaneously, while the others chose sequentially between two houses. All of the 13 children in the combined condition chose two different chocolates, while only half of the children in the separate condition did.