Solutions to the Asset Allocation Problem by Informed Respondents: The Significance of the Size-of-Bet and the 1/N Heuristic

Abstract

Asset allocation is a classic topic in the theory of finance, and a crucial issue for investment policy. Noted for its significance in driving pension fund performance, it is also an issue that individual investors consider when designing their investment portfolios. In theory, Markowitz and those following in his wake have an optimal solution. In practice, however, we demonstrate that when asked to allocate financial assets to a set of asset classes arrayed in order of their riskiness, most respondents would vary their investment strategies according to the size-of-bet (the value of assets to be invested). As in previously reported research on the competence and consistency of pension fund trustee decision-making, we show that there are a variety of solutions to the asset allocation problem. These cannot be solutions explained by social status, formal education or professional training. Observed differences in respondent solutions to the asset allocation problem are due to strategies that mix together intuitive responses to the initial tranche of money with rudimentary theoretical-cum-practical shared conventions. Solutions to the asset allocation problem suggest that the size-of-bet is a significant issue for many informed investors, contrary to commonplace assumptions. In conclusion, suggestions are made about taking forward closer scrutiny of these observed patterns.