Diversification Bias

The Basic Idea

When you’re going on a big grocery run, it can be difficult to choose what to buy for your future self. Even if you know what you like, you might wonder if your preferences will change or if you’ll get tired of what you always want. As a result, you might buy a wider variety than usual.

When it comes time to cook and eat the food you’ve bought, you’ll likely find your preferences have not changed drastically, and that you have more kinds of food than you actually want. This discrepancy results from a cognitive bias called diversification bias, or naive allocation.

Diversification bias describes people’s tendency to spread limited resources evenly over a set of possibilities. It can result in us choosing variety even when it does not align with our actual desires. We use the diversification bias to streamline our decision-making, but this can sometimes lead to choices that do not reflect what we actually want or what is best for us. As its other name implies, we act as if we are naive to our own preferences or history when we blindly choose to include more variety.

What consumers buy can be systematically influenced by how much they buy.

– Itamar Simonson

History

Given its role in our shopping habits, it’s no surprise diversification bias was born into a marketing context. Itamar Simonson studied how the timing of purchase decisions (how far in advance do we buy items before using them) and the quantity of items purchased impacted the variety of products selected by the consumer.¹

Participants were asked to imagine they were going to the store and were given a grocery list with items like yogurt, a drink, and fruit. The researchers provided several options, like different yogurt flavors, for each grocery item. Participants then chose items on a) one imagined trip for the next three days, or b) on three separate trips, each taking place on the day they planned to use the groceries. Simonson distinguished the first group’s condition as simultaneous choice and the second group’s as separate choice. The research revealed that on the single shopping trip to purchase food for three days, shoppers opted for more variety as compared with the shoppers that made separate trips each day.

Simonson was intrigued by the significant increase of “variety-seeking” behaviour in the first group as compared to the second. In another study, Simonson observed the same behaviour when families bought large quantities of yogurt.² When purchasing a bulk quantity in advance, families tended to buy more varied and unusual flavours than when they bought smaller quantities. With these results, Simonson showed that “what consumers buy can be systematically influenced by how much they buy.”² More specifically, something about simultaneous choice made it more likely for shoppers to choose more variety.

Simonson suggested that variety-seeking in simultaneous choice simplifies the thinking involved in making multiple decisions at once. Additionally, he proposed that variety-seeking mitigates risk; in case our preferences change, we will have various options to fall back on. A study in 1995 supported the results of Simonson’s studies on diversification bias and further investigated why it occurs.³ Two main factors behind diversification bias were identified: time contraction and choice bracketing.

The first factor, time contraction, describes our tendency to reduce amounts of time in our minds – when we are told to choose snacks for three days, we may imagine consuming the snack in shorter intervals than what three days actually feels like. Because we think there will be less time in between our snacks, we choose more variety so we will not get sick of one option, but in reality, the gap is longer than we imagined.

The second factor, choice bracketing, refers to the grouping of decisions together, often by time. In these studies on diversification bias, choices have been bracketed together into a simultaneous choice, or divided into separate choices. When we decide our snacks for the next few days all at once, variety looks more appealing. But when we make the same decision day by day, our focus is on one choice and we can follow our desire without the urge to reduce risk by diversifying.

Choice bracketing has significant implications for marketing decisions and consumer behaviour, as setting products together can influence the way a consumer makes a decision about a purchase. Meal kit companies may force a customer to make decisions about their meals a week in advance and in the same order, promoting orders for a variety of meals rather than multiple orders of the same meal. Even if a meal included does not completely appeal to the customer, they are more likely to make these diverse orders because they present a safe mix of options. Yet, if the consumer chose their meals each day, they would be more likely to choose the same thing or less variety.

Beyond Simonson’s first study of diversification bias in marketing, researchers have come to understand the substantial implications of this bias in psychology, management and economics – not to mention the decisions we make in our daily lives and personal finance.

Consequences

Understanding the biases present in our decision-making can help us avoid making uninformed choices. When we are aware of our diversification bias, we can account for it when making simultaneous choices and resist the urge to pick up more variety than we actually want.

Diversification bias is a clear example of how the presentation of choices can have an impact on consumer decisions. This concept is called choice architecture.⁴ Depending on if they present a simultaneous choice or separate choices,  choice architects can expect a decision-maker to choose differently. Moreover, organizing products by brand and by feature can have a different impact on how consumers consider their choices. Research has shown consumers choose differently when products are presented in separated pairs (product A + product B, A + C, and B + C) versus when they are presented in a larger group (products A, B, and C together).⁵

One of the most notable applications of diversification bias after it was first described by Simonson occurred in investment strategy. In a 2001 paper, Shlomo Benartzi and Richard H. Thaler described a trend of individuals taking on more personal responsibility in the allocation of their money into investments.⁶

Their research found that an approach characterized by diversification bias had become a common way for inexperienced investors to make their finance decisions. Benartzi and Thaler named this approach the “1/n strategy”: a naive diversification strategy where the investor simply divides their contributions equally amongst the possible funds in a plan. This simple strategy is naive in that the investor does not consider the various strengths or weaknesses of different funds in a portfolio. Although this approach makes it easier for inexperienced investors to decide where to allocate their contributions, it does not take into account the historical data associated with particular funds. Subsequent studies highlighted the highly intuitive nature of using the 1/n strategy, as opposed to data-driven strategies.⁷ Our intuition can push us to choose the safe and easy action, rather than a more research-intensive and complicated approach. Inexperienced investors can then fall into a pattern of blindly dividing their investment among the funds offered to them in a given portfolio.

If many people have a tendency to evenly spread their contributions across available funds, the real choice is made by the choice architect who decides on the specific funds to include in a portfolio offering. Consumers make the final decisions, but a significant part of that decision lies in what the business offers the consumer and how they go about presenting these options.

Controversies

Since diversification bias is common, we might not notice our tendency to aimlessly diversify our grocery budget or investment contribution. Diversification bias occurs during simultaneous choices, as first described by Simonson, so one way to reduce biased decisions could be to limit our simultaneous choices. Indeed, research has suggested that in two scenarios, separate choices produced better results than simultaneous choices.⁸ When study participants were asked to choose multiple audio tracks to listen to later, the group that made these choices all at once rated their enjoyment of the music lower than the group that chose their music on separate occasions. Similarly, when groups were asked to choose between gambles which had various likelihoods of winning, the group choosing multiple gambles at once picked options with lower expected returns than those who picked their gambles separately.

However, researchers who have studied diversification bias have also acknowledged that simultaneous choices can sometimes be preferable to separate choices, since we can look at the big picture of our decisions.³ If we are trying to improve our diet, for example, it is easier to make a simultaneous choice of healthy meals at the beginning of the week, rather than have to make the conscious choice of a well-balanced meal every day. When we have to make a decision every time we want to consume something, we may end up choosing momentary fulfillment over long-term goals to eat healthy. Moreover, in situations where we simply do not have the information to make an informed decision – like if we are buying snacks for a party with people we don’t know – diversification bias can be a safe resort. In these cases, simultaneous choice makes sense, so each type of choice – simultaneous and separate – is appropriate in different situations.

In finance, the 1/n naive diversification strategy has been criticized as a biased and uninformed approach to investment, but there are certain situations where this simple and safe approach has been found to be effective. In portfolios where there is a high level of ambiguity in the funds’ performances, a naive allocation strategy is relatively safe.⁹ In other words, if we cannot make a reliable prediction about a fund, or there is not enough historical data, a 1/n strategy is considered a safe bet. Even as a general rule, researchers have shown that 1/n can be a consistently effective strategy across various sets of funds.¹⁰

As a one-size-fits-all strategy, however, there will be situations where other kinds of allocation schemes are more appropriate. If we have more information about funds, such as investments that are known to be stable versus more volatile funds, we could better optimize our distribution. Casual investors may assume that because there is no way to predict what will happen that there is no point in strategizing, but while some risk is always present, we cannot optimize our investments by ignoring historical data. This also applies to the gambling study; we can reasonably use probabilities to pick the best gambles despite the risk involved.

As diversification bias occurs partly due to our desire to simplify decision-making, it can be difficult to counteract since we often just want to make an easy and safe choice for the future. As always, the best decision-making approach will depend on the situation, but understanding our tendency towards naive allocation when making simultaneous choices can help us prevent making uninformed decisions.

Related TDL Content

Naive Allocation

This article explains how to recognize naive allocation and illustrates the concept with real-life examples.

Choice Architecture

Our tendency to make different choices depending on the way our decisions are bundled means that those in charge of presenting these choices can have significant influence over our behaviour. This article introduces the concept of Choice Architecture, choice architects, and why this concept has such significant potential in behavioral science and business.

Sources

  1. Simonson, I. (1990). The Effect of Purchase Quantity and Timing on Variety-Seeking Behavior. Journal of Marketing Research, 27(2), 150-162. https://doi:10.2307/3172842
  2. Simonson, I., & Winer, R. S. (1992). The influence of purchase quantity and display format on consumer preference for variety. Journal of Consumer Research, 19(1), 133–138. https://doi.org/10.1086/209292
  3. Read, D., & Loewenstein, G. (1995). Diversification bias: Explaining the discrepancy in variety seeking between combined and separated choices. Journal of Experimental Psychology: Applied, 1(1), 34–49. https://doi.org/10.1037/1076-898X.1.1.34
  4. Simonson, I., Nowlis, S., & Lemon, K. (1993). The Effect of Local Consideration Sets on Global Choice Between Lower Price and Higher Quality. Marketing Science, 12(4), 357-377. https://doi.org/10.1287/mksc.12.4.357
  5. Johnson, E., Shu, S., Dellaert, B., Fox, C., Goldstein, D., Häubl, G., Larrick, R., Payne, J., Peters, E., Schkade, D., Wansink, B., & Weber, E. (2012). Beyond nudges: Tools of a choice architecture. Marketing Letters, 23. 487-504. https://10.1007/s11002-012-9186-1.
  6. Benartzi, S., and Thaler, R.S. (2001). “Naive Diversification Strategies in Defined Contribution Saving Plans.” American Economic Review, 91(1), 79-98. https://doi.org/10.1257/aer.91.1.79
  7. Fernandes, D. (2013). The 1/N Rule revisited: Heterogeneity in the naïve diversification bias. International Journal of Research in Marketing, 30(3), 310-313. https://doi.org/10.1016/j.ijresmar.2013.04.001.
  8. Read, D., Antonides, G., van den Ouden, L., & Trienekens, H. (2001). Which Is Better: Simultaneous or Sequential Choice?. Organizational behavior and human decision processes, 84(1), 54–70. https://doi.org/10.1006/obhd.2000.2917
  9. Pflug, G., Pichler, A., & Wozabal, D. (2012). The 1/N investment strategy is optimal under high model ambiguity. Journal of Banking & Finance,36(2), 410-417. https://doi.org/10.1016/j.jbankfin.2011.07.018.
  10. DeMiguel, V., Garlappi, L., & Uppal, A. (2009). Optimal Versus Naive Diversification: How Inefficient is the 1/N Portfolio Strategy? The Review of Financial Studies, 22(5), 1915–1953, https://doi.org/10.1093/rfs/hhm075

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