Illusion of control as a source of poor diversification: An experimental approach

This paper investigates factors influencing individual portfolio allocations with particular focus on the role of illusion of control. By forming their portfolio of two risky lotteries and one risk-less alternative, subjects are requested to reach a target investment profit, whereby equal diversification between the two risky lotteries is part of the solution space. Subjects however excessively invest in the lottery for which they can determine the outcome by rolling the die themselves indicating that they are prone to illusion of control. However, the effect vanishes with experience. In contrast, presenting random sequences of prior outcomes reduces biased investments. In line with the excessive extrapolation hypothesis, the more positive outcomes observed from past draws, the more likely is a positive prediction for this lottery, which is then followed by higher investment. Also, offering a default portfolio strongly determines final allocations.