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Diversification Decisions of Individual Investors and Asset Prices

Author

Listed:
  • Alok Kumar

    (Mendoza College of Business)

  • William N. Goetzmann

    (Yale University, 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

Suggested Citation

  • Alok Kumar & William N. Goetzmann, 2003. "Diversification Decisions of Individual Investors and Asset Prices," Yale School of Management Working Papers ysm441, Yale School of Management.
    • Handle: RePEc:ysm:somwrk:ysm441
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    File URL: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=469441
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    Cited by:

    1. Nicolosi, Gina & Peng, Liang & Zhu, Ning, 2009. "Do individual investors learn from their trading experience?," Journal of Financial Markets, Elsevier, vol. 12(2), pages 317-336, May.
    2. Bose, Udichibarna & MacDonald, Ronald & Tsoukas, Serafeim, 2015. "Education and the local equity bias around the world," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 39(C), pages 65-88.
    3. Stijn Van Nieuwerburgh & Laura Veldkamp, 2010. "Information Acquisition and Under-Diversification," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 77(2), pages 779-805.
    4. Mizrach, Bruce & Weerts, Susan, 2009. "Experts online: An analysis of trading activity in a public Internet chat room," Journal of Economic Behavior & Organization, Elsevier, vol. 70(1-2), pages 266-281, May.
    5. Gina Nicolosi & Liang Peng & Ning Zhu, 2003. "Do Individual Investors Learn from Their Trading Experience?," Yale School of Management Working Papers ysm439, Yale School of Management, revised 01 Sep 2009.
    6. Bose, Udichibarna & MacDonald, Ronald & Tsoukas, Serafeim, 2015. "Education and the local equity bias around the world," 2007 Annual Meeting, July 29-August 1, 2007, Portland, Oregon TN 2015-76, American Agricultural Economics Association (New Name 2008: Agricultural and Applied Economics Association).

    More about this item

    Keywords

    Individual investors; Diversification; Idiosyncratic risk; Behavioral biases; Asset pricing.;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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