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Diversification Decisions of Individual Investors and Asset Prices

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Author Info

  • 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

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Bibliographic Info

Paper provided by Yale School of Management in its series Yale School of Management Working Papers with number ysm441.

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Date of creation: 21 Nov 2003
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Handle: RePEc:ysm:somwrk:ysm441

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Web page: http://icf.som.yale.edu/
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Related research

Keywords: Individual investors; Diversification; Idiosyncratic risk; Behavioral biases; Asset pricing.;

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Cited by:
  1. Stijn Van Nieuwerburgh & Laura Veldkamp, 2008. "Information Acquisition and Under-Diversification," NBER Working Papers 13904, National Bureau of Economic Research, Inc.
  2. Bruce Mizrach & Susan Weerts, 2004. "Experts Online: An Analysis of Trading Activity in a Public Internet Chat Room," Departmental Working Papers 200412, Rutgers University, Department of Economics.
  3. Gina Nicolosi & Liang Peng, 2004. "Do individual investors learn from their trading experience," Econometric Society 2004 North American Summer Meetings 532, Econometric Society.

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