Adaptive behavior leads to under-diversification

In a given period a diversified fund by virtue of being a weighted average will perform somewhere in the middle range of its components respective performances This means that adaptive investors who look to the past to adjust expectations about future returns will shun diversified funds That is adaptive reaction to feedback implies under diversification when the investor gets complete feedback on the performance of the diversified fund as well is its components in a given period Three laboratory experiments and one quasi field experiment explore this possibility and its implications We find that the avail ability of complete feedback drastically reduces diversification Under diversification is observed even when the decision makers receive a complete description of the payoff distributions and when under diversification lowers expected return (C) 2010 Elsevier BV All rights reserved