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Equity Portfolio Diversification

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  • William N. Goetzmann
  • Alok Kumar

Abstract

In this paper we examine the portfolios of more than 40,000 equity investment accounts from a large discount brokerage during a six year period (1991-96) in recent U.S. capital market history. Using the historical performance for the equities in these accounts, we find that a vast majority of investors in our sample are under-diversified. Even accounting for the likelihood we have selected on speculators, the magnitude of the diosyncratic risk taken by investors in our sample is surprising. Investors are aware of the benefits of diversification but they appear to adopt a 'naive' diversification strategy where they form portfolios without giving proper consideration to the correlations among the stocks. Over time, the degree of diversification among investor portfolios has improved but these improvements result primarily from changes in the correlation structure of the US equity market. Cross-sectional variations in diversification across demographic groups suggest that investors in low income and non-professional categories hold the least diversified portfolios. In addition, we find that young, active investors are over-focused and hold under-diversified portfolios. Overall, our results indicate that investors realize the benefits of diversification but they face a daunting task of 'implementing' and maintaining a well-diversified portfolio.

Suggested Citation

  • William N. Goetzmann & Alok Kumar, 2001. "Equity Portfolio Diversification," NBER Working Papers 8686, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:8686
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    References listed on IDEAS

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    1. Huberman, Gur, 2001. "Familiarity Breeds Investment," Review of Financial Studies, Society for Financial Studies, vol. 14(3), pages 659-680.
    2. Blume, Marshall E & Friend, Irwin, 1975. "The Asset Structure of Individual Portfolios and Some Implications for Utility Functions," Journal of Finance, American Finance Association, vol. 30(2), pages 585-603, May.
    3. Cohn, Richard A, et al, 1975. "Individual Investor Risk Aversion and Investment Portfolio Composition," Journal of Finance, American Finance Association, vol. 30(2), pages 605-620, May.
    4. John Heaton & Deborah Lucas, 2000. "Portfolio Choice and Asset Prices: The Importance of Entrepreneurial Risk," Journal of Finance, American Finance Association, vol. 55(3), pages 1163-1198, June.
    5. Merton, Robert C, 1987. " A Simple Model of Capital Market Equilibrium with Incomplete Information," Journal of Finance, American Finance Association, vol. 42(3), pages 483-510, July.
    6. Perraudin, William R. M. & Sorensen, Bent E., 2000. "The demand for risky assets: Sample selection and household portfolios," Journal of Econometrics, Elsevier, vol. 97(1), pages 117-144, July.
    7. De Bondt, Werner F. M., 1998. "A portrait of the individual investor," European Economic Review, Elsevier, vol. 42(3-5), pages 831-844, May.
    8. R. S. Uhler & J. G. Cragg, 1971. "The Structure of the Asset Portfolios of Households," Review of Economic Studies, Oxford University Press, vol. 38(3), pages 341-357.
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    JEL classification:

    • G0 - Financial Economics - - General
    • G1 - Financial Economics - - General Financial Markets

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