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Focusing on volatility information instead of portfolio weights as an aid to investor decisions

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Abstract

When faced with the challenge of forming a portfolio containing a risky and a risk-free asset, investors tend to apply the same portfolio weights independently of the volatility of the risky asset. This “percentage heuristic” can lead to different levels of portfolio risk when the same investor is presented with a more or a less risky asset. Using four experiments, we show that asking investors to choose the return distribution for their portfolio while keeping the exact portfolio weights unknown leads to greater similarity in levels of portfolio volatility (across different levels of risk of the risky asset) than asking investors to choose this distribution while additionally facing the portfolio weights. Higher consistency in risk taking is obtained both between and within test subjects.

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Notes

  1. Experimental instructions are depicted word for word in the “Appendix”.

  2. Alternative starting points (50:50; 2/3–1/3) were used in a pre-test and did not seem to influence general risk taking.

  3. This is not perfectly true, as participants in the low-risk asset group would need an allocation above 100% to reach a risk-return profile similar to that of a person in the high-risk asset group investing 100% into the risky asset. However, as subjects already face a complex decision, the task is kept simple by omitting such a borrowing possibility.

  4. As most private investors can potentially take out credits, borrowing could conceivably be allowed. However, as subjects already face a complex decision, the task is kept simple by omitting a borrowing possibility. Furthermore, in actuality investors are often discouraged from buying risky assets on credit, which could affect the results: even subjects understanding the design might be reluctant to take out credit.

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Acknowledgements

We thank Peter Bossaert, Christopher Hrdlicka, Annika Kasparek, Christoph Merkle, Florian Muenkel, Alexandra Niessen-Ruenzi, Andrew Siegel, Stephan Siegel, Olga Tyurina, and Stefan Zeisberger for helpful comments and discussions. We would also like to thank (seminar) participants at the Subjective Probability, Utility, and Decision Making Conference, the Boulder Summer Conference on Financial Decision Making, the Experimental Finance Conference, the Research in Behavioral Finance Conference, the Frankfurt School of Finance and Management, University of Lausanne, University of Navarra, as well as the University of Washington for valuable comments. Finally, we thank Nils Kaufmann and Janick Edinger for programming the experiment. We gratefully acknowledge research funding from the Karin Islinger Stiftung.

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Correspondence to Christine Laudenbach.

Appendix: experimental instructions

Appendix: experimental instructions

Page 1 Welcome to our experiment on financial decision making. In the following, we will ask you to make an investment decision for a 5 year horizon.

After you decide, we will conduct a “financial” market simulation” to determine the 5 year return on your decision. This simulation will randomly generate a return based on the underlying distribution of the risk-free and the riskier investment, you have chosen.

This amount divided by 100 is the amount you will be paid as a bonus if you are one of the participants chosen to be paid based on your decision (you have a 1 in 40 chance of being chosen).

Page 2 Please imagine you want to invest $1000 over a 5 year time horizon. You will have the chance to invest in the following portfolio consisting of a risky and a risk free asset.

Page 3 start with the simulation, which is depicted in Fig. 2.

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Ehm, C., Laudenbach, C. & Weber, M. Focusing on volatility information instead of portfolio weights as an aid to investor decisions. Exp Econ 21, 457–480 (2018). https://doi.org/10.1007/s10683-017-9537-0

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  • DOI: https://doi.org/10.1007/s10683-017-9537-0

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