From Potluck to Portfolio: Understanding Our Diversification Heuristic and Mastering Our Decision Making

In this episode, Dr. Bryan Foltice explains the diversification heuristic as a mental shortcut that often leads to smarter choices but can backfire in the wrong context. 

Using a buffet example and evolutionary reasoning, he shows how people naturally try a little of everything to avoid regret. 

He reviews research on sequential versus simultaneous choice: Simonson (1990) found far more variety when people choose for multiple weeks at once, and Read & Loewenstein (1999) showed children diversify more when choosing two candies together. 

In finance, Benartzi & Thaler (2001) and TIAA-CREF data illustrate “1/N” allocation, including Markowitz’s regret-minimizing 50/50 stock-bond split, which can ignore true risk tolerance. 

Foltice highlights pitfalls like overlapping funds (SPY vs. VOO), buying unfamiliar assets (e.g., crypto) for “diversification,” and over-diversifying time, concluding that awareness helps clients and individuals apply diversification appropriately.

Transcript

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SPEAKER_00 0:04

Welcome to the Brian Fultis Behavioral Finance Podcast, where we unravel the mysteries of behavioral finance and unlock the secrets to making smarter, more informed decisions with your money. Now, here's your host, Dr. Brian Fultis.

SPEAKER_01 0:24

Hey, welcome everybody. I am super excited to present this week's topic because this topic is actually something that we're good at, and that is called diversification. We're going to talk about the diversification heuristic or bias, and we're going to talk about how it leads us into good decisions and how we can very naturally do this, but then also it can lead us into some bad decisions. We're going to take a look into the literature, do a deep dive into this, and uh sort out the different ways that we diversify both good and bad. So thank you very much for tuning in and watching us. We're going to jump right into this. Remember, diversification, heuristic, this is our natural tendency to be able to diversify. So when we think of heuristics, heuristic is simply a mental shortcut, something that is our automatic thinking device that can sometimes lead us into the right decisions and we don't spend a ton of mental energy on it, but also it can backfire if we use it in the inappropriate context. I am now married to a nurse, and one of the perks around that is we get invited to some of these buffets or potlucks from the surgeons and the doctors, and we get to go to their nice neighborhood and their spread. And then, of course, the doctor is normally married to another doctor, and so it just makes it even more special, and we get to eat everybody's food that they've spread out, and it's just a bunch of different awesome options. So as you go through there, you're just gonna unabashedly take a little bit of everything that's on the menu because I don't want to miss out and have regret that I missed out on something good. So I'm just gonna try, you know, even like a first round or two of a little bit of everything, and then I can always go back and add a little bit more if I want to. And and so you think about I'm very naturally good at diversifying, and we think about our evolution, um, that you go back and our diversification of food sources, that we won't want to always tap into one food source or hunt one particular animal. We're gonna try to spread those eggs out. We're not gonna go in the same berry patch. Now, of course, I'm thinking about this because my wife and I we just watched uh a ton of Alone on Netflix. And so you got to see them hunting different fish, but they also have the rabbit snares and they're trying to navigate that and they're gonna uh budget some you know, moss and the berries in different places as well. So anyway, um, we're good at this. We're we're naturally good, and we have this wired in our mind that we can diversify fairly well. When we look at some of the research here, um we look into a couple of things. We found out this is going back to 1990, okay? Actually, before that, uh fourth century, this is now in the Talmud, uh, the Jewish um texts. And this comes from uh Rabbi Isaac Bar Aha, and his advice around money is to take one-third of overall money, put it into land, one-third put it into merchandise, and then one-third keep it at hand. And that's how he advised um people on money back in the fourth century. How? This spread it out over time. Uh now to the academic literature, 1990. This is now uh Itmar Simonson in the Journal of Marketing Research, and he gave everybody six different snacks. Now, this is in his classes, and he gave everybody the option of differ six different snacks. There was a candy bar, there was an Oreo, trying to remember, just reading it earlier today, and then there were some peanuts and some tortilla chips, so in different options, but uh six different ones. And he asked students every week for three weeks what they would choose, and he noticed that every one of six that nine percent of the students chose something different. And he went back and did a different group and gave them six options, simultaneous choice for the next three weeks. Okay, so instead of staggering the decision, which is called the sequential choice once every week, he gave one choice for the next three weeks right now. And he noticed that 64% of the students chose something different. So now we're noticing something here that once we provide options in one sitting, we're even more naturally diversified. That's just like if I were at the the potluck, where it's it's one choice, all these different options, we revert to diversification. That's when it becomes natural. And this study shows that we don't always naturally diversify and we don't think back, it's just in that moment, what do I want? And our preferences can stay consistent um in those given times. But when we have the menu at one particular point, we become very good at diversification. Um 1999, moving a little bit forward. This is our journal of uh experimental psychology. So, JEP, as we know, JEP in our world of academics. This was uh Reed and Lumenstein. And so they did this a little bit differently. They did Halloween candy, and they offered a Milky Way and a Three Musketeers. And for the sequential order, and they call this uh separate choice bracketing, but it's set essentially in kind of the same sequential order that you go to one house, you're offered Milky Way and Three Musketeers. You go to the second house, you're offered Milky Way Three Musketeers. Um, 48 uh percent of those children with their candy chose something different in each particular house when had when both options were presented to them in both houses. If the third house had a different treatment, they actually had um combined choice. So they had uh a big volume of both types of candy and told each child that you may have two pieces of candy out of any of these candies that are offered. Now, of course, they had just a ton of three musketeers and three uh and a ton of Milky Ways, and 100% of those kids actually took one of each. So once again, simultaneous choice, we're diversified. Um even when we have two options, and then when we have the separate one, we kind of more or less uh choose what we want. So now, this is behavioral finance, right? We're gonna bring this into the world of behavioral finance, and that's what Slomo, Bernardzi, and Dick Thaler did in the American Economic Review of 2001, where they showed investment options. This is where we choose our portfolio. Now, this is a very much a one-time, simultaneous look-at-a-menu situation where we try to make our portfolio asset allocation. And, you know, they found that originally TIA Crep, um, the retirement plan provider, initially only offered two options to people. And they found that uh you could do the stock um mutual fund or you could do the bond mutual fund. And they found that by far the most common asset allocation from that was 50-50. Just put it 50-50 and invest. In fact, all nearly half of the participants did this 50-50 asset allocation. And in that was this quote that says, it's always my favorite. It says, My intention was to minimize my future regrets. So when I'm making this decision, I put 50% in stocks and 50% in bonds with my contributions. And so when you think about who said that, I could just be any investor. Um, but that was actually Harry Markowitz who invented the efficient frontier and the capital asset pricing model. Uh, even he, when he was trying to explain his contributions, said, Yeah, uh I know what I'm supposed to do, but I'm going to just split my decision halfway so I don't regret what I've done uh in either direction. And so now TIAA Cref now has a number of different options uh for your investment. And this is where the one divided by n, and so the number of options, becomes in play. And they found within their settings, and they did a number of different um uh tests and and experiments in different ways, and they at the end of the day, they found out that, yeah, no matter how many options were given, uh they're going, people in general are going to just diversify among whatever is given to them. And this can be a problem because it won't necessarily reflect their risk attitude. It's basically whatever the options are. So if half of the options are stock options and the other are bond options, well, people are gonna naturally be 50-50, even if they're 22 years old and can have a higher risk tolerance, or wherever they fall on that risk spectrum, they're gonna be 50-50. And then most of the time, that does not fit people's proper asset allocation. And so we see this in finance, we see this among ourselves, and in a lot of the ways, this is very, very good, this diversification heuristic. Now, we think about it's natural. Think about not eating our food. We don't have to eat the same food every day, even in modern day, even the same meal or same dinner, we diversify that. What sounds good right now, and it changes, but we can spread that out a little bit over time. Music that we listen to, we spread that out and listen to the same music day after day. Our social uh group that we have, our social network, can be very diversified as well. And again, this all comes naturally, it's all good. Vacations, as much as I like to go back to some of these same destinations, there's always a part of me that goes, I probably want to try something new. And usually I don't regret that. And our vacation destinations, we can vary that as well. But sometimes, and this can lead us into bad decisions. We talked about asset allocation in your portfolio. We've seen that, especially when the company offers these life cycle funds, which have there's supposed to be a standalone, but many people just use that life cycle fund as one of many different positions in their account. And when you're trying to assess what their actual stock bond asset allocation exposure is, it gets a little bit murky because it's supposed to be a standalone that will adjust over time. And but now it's just like a fraction of what they already have. So again, uh can lead us to bad decisions. We can see this sometimes when people are trying to diversify among their investments. They have some SPY and they have some VU, and you're going, that's not diversification, it's the same underlying securities, and you just have two different positions in this. And we see this oftentimes with different large caps. It's something new opportunity spun, the Magellan Fun, this Explorer Fun, whatever. They're all large cap, and people think they're diversified, although they just have a ton of exposure to large cap stocks. Buying investments you don't understand just for the sake of diversification. This is something that many of us do and leads us into most of the time some bad decisions. This is where people say, Well, I should probably buy some Bitcoin and then among my cryptos, I should probably get some etherong and or doge or whatever within that, even though we don't understand what that actually means or is. It's just in the name of thinking that we're supposed to diversify. And again, leading us can potentially into some bad decisions. And then finally, another bad manifestation of this diversification effect is our time diversification. And what I mean by that is what do we actually focus our time on? Are we supposed to be average at 10 different things, or should we just be good at one thing? And we've seen this happen a lot of times. I've seen this in my world, trying to spread all these eggs out, but then realizing that I'm doing less than a half-ass job in all of these areas, and it's time to hone in, chop off some of the the fat, and then really dial in on the one thing that you want to do. And that's presenting hairs. Uh, actually. So, what are we gonna do with this? We we know that we're good at diversification, we can see it working in our lives well. We also know there's some pitfalls and some dangers that we can also fall into. And so our takeaway here is with this knowledge, with this awareness, is that having awareness of the good and bad when it works for us, when it doesn't. If I'm uh advising clients, understanding their natural tendency to want to do this and to have some conversations around whether or not that makes sense or how it fits their risk profile, having that conversation as well. And then understanding when it doesn't serve you, we can reroute. And but it starts with that awareness, understanding when it hurts you, and then trying to triage and change that behavior. That's all I have today. We're gonna continue this conversation next week because I have a question that I've been wrestling with for a very long time around this topic. We're just gonna piggyback on this conversation and move straight into next week. Hope you enjoyed today's episode. If you have any questions, comments, would love to hear from you, ideas about another show. Let's have that conversation. We'd love to hear from you. If you liked what you heard today and want to continue, please subscribe. That also kicks the algorithm into some more viewers' hands. And hopefully we continue to make this topic of behavioral finance more and more popular as we go on week by week. So thanks again for watching. Hope you have a great day, and we'll see you on the next episode. Thanks, everyone.

unknown 17:09

Bye.

SPEAKER_00 17:12

Thank you for tuning in to another episode of the Brian Fultis Behavioral Finance Podcast. We hope you found our exploration into the fascinating world of human behavior and finance, both enlightening and thought provoking. Be sure to subscribe for future episodes. And until next time, stay curious and financially savvy.