Diversification Decisions of Individual Investors and Asset Prices

Alok Kumar () and William Goetzmann
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Alok Kumar: Mendoza College of Business

Yale School of Management Working Papers from Yale School of Management

Abstract: In this paper, we examine if the diversification decisions of individual investors influence asset prices. First, we show that a vast majority of individual investors in our sample are under-diversified and the unexpectedly high idiosyncratic risk in their portfolios results in a welfare loss - the least diversified group of investors earn 2.40% lower return annually than the most diversified group of investors on a risk-adjusted basis. Next, we examine the determinants of investors' under-diversification and find that younger, low-income, and relatively less sophisticated investors hold less diversified portfolios. In addition, investors who prefer skewness, exhibit relatively stronger familiarity bias, and exhibit greater over-confidence are less diversified. Finally, we show that the systematic under-diversification of individual investors influence asset prices. A zero-cost portfolio (DIV factor) that takes a long position in stocks with the least diversified individual investor clientele and a short position in stocks with the most diversified individual investor clientele earns an annual excess return of 7.44% on a risk-adjusted basis. Furthermore, this factor has power to explain the cross-sectional variation in returns for a considerable group of stocks

Keywords: Individual investors; Diversification; Idiosyncratic risk; Behavioral biases; Asset pricing. (search for similar items in EconPapers)
JEL-codes: G11 G12 (search for similar items in EconPapers)
Date: 2003-11-21
New Economics Papers: this item is included in nep-cfn and nep-fin
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Citations: View citations in EconPapers (9)

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Persistent link: https://EconPapers.repec.org/RePEc:ysm:somwrk:ysm441

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