The Perceived Diversity Heuristic: The Case of Pseudodiversity Shahar Ayal The Open University of Israel and Duke University Dan Zakay Tel Aviv University and Interdisciplinary Center (IDC) Herzliya One of the normative ways to decrease the risk of a pool with uncertainty prospects is to diversify its resources. Thus, decision makers are advised not to put all their eggs in one basket. The authors suggest that decision makers use a perceived diversity heuristic (PDH) to evaluate the risk of a pool by intuitively assessing the diversity of its sources. This heuristic yields biased judgments in cases of pseudodiversity, in which the perceived diversity of a pool is enhanced, although this fact does not change the pool’s normative values. The first 3 studies introduce 2 independent sources of pseudodiversity— distinctiveness and multiplicity—showing that these two sources can lead to overdiversification under conditions of gain. In another set of 3 studies, the authors examine the effect of framing on diversification level. The results support the PDH predictions, according to which diversity seeking is obtained under conditions of gain, whereas diversity aversion is obtained under conditions of loss. Keywords: diversification, risk perception, heuristics, biases, framing It is the part of a wise man to keep himself today for tomorrow, and not venture all his eggs in one basket. —Sancho Panza in Miguel de Cervantes, Don Quixote Decision makers often have to evaluate and choose among pools of uncertain outcomes. For instance, people have to decide how many funds and what kind should be combined in their portfolio pool. Similar considerations apply to a choice among four different medical insurance plans that involve differential costs and benefits. In both examples, decision makers must compare distributions of prospective outcomes that can be represented by two measures: the expected value and the variance. According to theories of traditional economics, the expected value of each pool represents its utility, and the variance of each pool represents its associated risk. When the variance increases, the degree of risk increases as well (Baron, 1978). One of the normative ways to reduce this risk is to diversify the sources of investment. For example, according to portfolio theory (Coombs, 1975; Markowitz, 1952), risk can be reduced by combining dif- ferent stocks (e.g., technology, oil, and health care) in the same portfolio, such that poor performance in one field will be offset by better performance in others. Thus, as Cervantes and conventional wisdom have pointed out, a wise decision maker is advised to not put all his or her eggs in one basket but to distribute them in several baskets instead. To determine whether people understand this idea intuitively, one must examine how people evaluate the risk involved in their decision. It appears that people exhibit a reasonable intuitive ability to identify fluctuations in the variance of stimuli (Kareev, Arnon, & Horwitz-Zeliger, 2002; March, 1996; Peterson & Beach, 1967; Pollard, 1984). Weber, Shafir, and Blais (2004) reported that the best predictor of the decision among pools of uncertain pros- pects was the coefficient of variation; that is, the ratio between the standard deviation and the expected value of the pool. According to this measure, the investment is better when this ratio is lower (Baron, 1978). However, the attempt to reduce risk by increasing diversity among several sources leads to biases. A variety of studies have shown a strong tendency toward naı ¨ve diversification under con- ditions of gains. This tendency has been labeled the variety seeking behavior (McAlister & Pessemier, 1982; McAlister & Pessemier, 1982; Simonson, 1990), the diversification bias (Read & Loewen- stein, 1995), and the irrational diversification (Rubinstein, 2002). Benartzi and Thaler (2001) specifically examined how individuals deal with the complex problem of the selection of a portfolio for their retirement accounts. The results of this study demonstrated that most investors follow the 1/n strategy: they divide their contributions evenly over the funds available in the plan (see also Hedesstrom, Svedsater, & Garling, 2006; Langer & Fox, 2005). The aim of the present work is to propose and test a general theoretical framework for the conceptualization of the effect of perceived diversity on judgments and choice. Our basic assump- tion is that decision makers intuitively understand the portfolio theory logic described above and develop a rule of thumb with which to evaluate the risk of a pool by assessing the diversity of its sources. We label this intuitive strategy the perceived diversity heuristic (PDH), according to which the higher the perceived diversity, the lower the risk. Similar to other heuristics (Gilovich, Griffin, & Kahneman, 2002; Tversky & Kahneman, 1974), this proposed heuristic is useful and adaptive in certain situations, but leads to biases in other situations. Shahar Ayal, Department of Education and Psychology, The Open University of Israel, Raanana, Israel, and Fuqua School of Business, Duke University; Dan Zakay, Department of Psychology, Tel Aviv University, Tel Aviv, Israel, and Interdisciplinary Center (IDC) Herzliya, Herzliya, Israel. This research was primarily conducted at the psychology lab of The Open University of Israel while Shahar Ayal was employed there. We thank The Open University for its financial support. Correspondence concerning this article should be addressed to Shahar Ayal, Fuqua School of Business, Duke University, 1 Towerview Drive, Durham 27708, NC. E-mail: s.ayal@duke.edu Journal of Personality and Social Psychology © 2009 American Psychological Association 2009, Vol. 96, No. 3, 559 –573 0022-3514/09/$12.00 DOI: 10.1037/a0013906 559