Easy, breezy, risky: Lay investors fail to diversify because correlated assets feel more fluent and less risky

Abstract

Why do people fail to diversify risk in their investment portfolios? We study how lay investors (people with low financial literacy) invest in financial assets whose past or expected returns are provided. Although investing in assets with negatively correlated returns reduces portfolio risk (i.e., reduces portfolio fluctuations), we find that lay investors instead prefer investing in assets with positively correlated returns, which results in less diversified and riskier investment portfolios than intended. Using a mixed-method approach, we find that lay investors rely on a lay perception of portfolio risk: assets with positively correlated returns feel more fluent (more familiar, simple, and predictable), and thus are erroneously perceived as less risky. We find that lay investors succeed in forming diversified, lower-risk portfolios when they are provided with aggregate portfolio returns, or when—paradoxically—they are encouraged to take more risk.