Opportunity Costs of Sub-Optimal Diversification

Abstract

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.