The Willingness to Pay for Diversification

Abstract

Diversification is a fundamental concept in economics, finance, and decision theory. This paper argues that decision makers assign an intrinsic value to the notion of diversification and that this “willingness to pay” is driven by risk aversion and loss aversion. In an experimental study replicating a portfolio choice problem using simple gambles, the value of diversification is elicited and estimated to be at 5% of the initial endowment. The experiment further shows that risk averse and loss averse individuals are willing to pay more for diversification. The paper’s findings point to the idea that diversification is an intrinsic behavioral heuristic and may help explain some portfolio choice anomalies in practice, such as irrational diversification, the diversification bias, and overdiversification.