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There is a worldwide trend toward defined contribution saving plans and growing interest in privatized Social Security plans. In both environments, individuals are given some responsibility to make their own asset-allocation decisions, raising concerns about how well they do at this task. This paper investigates one aspect of the task, namely diversification. We show that some investors follow the "ln strategy": they divide their contributions evenly across the funds offered in the plan. Consistent with this naive notion of diversification, we find that the proportion invested in stocks depends strongly on the proportion of stock funds in the plan. (JEL G11, G23, H55)
There is a worldwide trend toward defined contribution saving plans in which investment decisions are made by the plan participants themselves (Employee Benefit Research Institute, 1997). While the advantages of such plans are numerous (e.g., the plans tend to be fully funded and portable), many have expressed concern about the quality of the decisions being made by the participants (e.g., Olivia S. Mitchell and Stephen P. Zeldes, 1996). One of the reasons for concern is the lack of financial sophistication in the general public (B. Douglas Bernheim, 1996). To illustrate, a 1995 survey by John Hancock Financial Services found that a majority of respondents thought money market funds were riskier than government bonds, and felt that their own company stock was safer than a diversified portfolio.
Of course, it is possible that poorly informed employees are still making good decisions. How can we evaluate whether plan participants are making good choices in what is arguably the most important financial decision of their lives? We do not attempt to evaluate asset allocations on an individual case-by-case basis because nearly any combination of stocks and bonds could, in principle, be consistent with the maximization of some utility function. Rather, in this paper we look for evidence that participants make decisions that seem to be based on naive (or confused) notions of diversification. One extreme example we discuss is what we call the "1/n heuristic". Someone using this rule simply divides her contributions evenly among the n options offered in her retirement savings plan.
The use of the 1/n rule has a long history in asset allocation. In fact, it was recommended in the...