The practical relevance of the extensive theoretical literature on optimal diversification has been brought into question by a wide variety of research that suggests individual investors utilize investment principles that are distinctly sub-optimal relative to theoretical principles. If these indications are indeed legitimate, this might be owing to the irrationality of investors, or to imperfections in the theoretical models. The present research suggests a third possibility: that the numerical payoff to optimal diversification is relatively minor. On the basis of a numerically implemented and empirically supported model of optimal diversification developed by Yunker and Melkumian (2010), the present research finds that the numerical opportunity costs (welfare losses) from sub-optimal diversification are quite minor even for substantial departures from the optimal levels of the decision variables. The suggestion from the research is therefore that individual investors tend to "satisfice" rather than "maximize" or "optimize" in making their diversification decisions.
Journal of Economic LiteratureClassifications: G11 (Portfolio Choice, Investment Decisions)
I explore investors' welfare losses when they restrict themselves to invest in either stocks only or bonds only, but not in both. The restriction gives investors sub-optimal asset allocations that result in welfare losses. To measure these welfare losses I compare "only stock indices and Treasury bills" optimal portfolios and "only bond indices and Treasury bills" optimal portfolios with "stock and bond indices and Treasury bills" optimal portfolios using the concept of proportionate opportunity cost along with various CRRA utility functions. The original historical asset returns data set is used with a VAR in generating joint returns distributions for the portfolio formation period. I show that for investors with low levels of risk aversion welfare losses do not exceed 1.8% of initial wealth when they invest sub-optimally. For investors with medium and high levels of relative risk aversion, suboptimal portfolios of only one type of assets, stocks only or bonds only, along with Treasury bills, give expected utility about as high as optimal portfolios that include both types of assets, stocks and bonds.
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