The misuse of diversification and the analogical transfer of decision heuristics: an experimental analysis

Diversification is an effective investment strategy for dealing with risky alternatives, but sometimes it can be a misleading heuristic. For example, when the payoff function is convex the variance of the random variables should increase the incentive to invest. Even in these situations, however, individuals may be tempted to apply a diversification heuristic and choose the less variable alternative. We conducted a series of experiments on decision tasks in which it is stochastically dominant to choose an alternative with higher variance. Subjects systematically preferred the dominated, lower variance alternative. Attempts to manipulate the availability of alternative decision heuristics by providing subjects with alternative stories or by decision tasks often associated to aggressive risk taking (winner-take-all tournaments) significantly reduced the bias, suggesting that an analogical, similarity based transfer of decision heuristics plays a central role in the diversification bias. This appears to be in accordance with both case base decision making theory and psychological theories of analogy making.