Risk aversion and under-hedging

In a series of experiments, subjects allocate an endowment between assets. One of the assets, a bond or a composite asset, is dominated by a combination of two volatile assets. We explore settings and preferences that result in the dominated asset being chosen. The results show that subjects persist in allocating a significant portion of their funds to the dominated asset after 200 rounds. This finding can be explained by risk-averse investors’ inability to treat a combination of assets as a single distribution of payoffs. We find that risk-averse investors are more likely to persist in choosing dominated assets.