Narrow Framing and Under-Diversification: Empirical Evidence from Chinese Households

Abstract

“Narrow framing” is a widely documented behavioral bias that predicts, instead of evaluating all their risk components as a whole, people often evaluate risks in isolation, separately from other risks they are already facing. Using representative survey data from the China Household Finance Survey (CHFS), we estimate the extent of narrow framing among Chinese households, using their portfolio choices. Conditional on stock market participation, we find most Chinese households exhibit significant narrow framing. Based on the obtained estimates, we investigate whether the variation in narrow framing can help to explain households’ diversification decisions cross-sectionally. Our results support the theoretical view that narrow framing negatively predicts the extent of diversification. Most importantly, we argue that narrow framing is an irreplaceable ingredient of understanding households' portfolio choices, even after considering measurement error and a wide set of indicators of under-diversification.