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Risk aversion , Under-diversification , and the Role of Recency and Probability Matching

Two experiments are presented that compare alternative explanations to the coexistence of risk aversion and under-diversification (the tendency to focus on few stocks) in investment decisions. The participants were asked to select one of three assets under two feedback conditions. The returns from two assets were negatively correlated, and the third asset was equally weighted combination of the other two, allowing for lower volatility. The popularity of the weighted asset was highly sensitive to feedback condition. It was the most popular asset when the feedback was limited to the obtained payoff, but the least popular asset when the feedback included information concerning forgone payoffs. This pattern supports the assertion that under-diversification can be a product of momentum trading and/or probability matching.