Diversification Decisions of Individual Investors and Asset Prices

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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