Diversification Decisions of Individual Investors and Asset Prices ∗

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. U.S. equity risk has a large idiosyncratic component, much of which may be reduced through portfolio diversification. Most rational models of investor choice suggest that investors hold diversified portfolios to reduce or eliminate non-compensated risk and virtually all asset pricing models posit that securities are priced by a diversified, marginal investor who demands little or no compensation for holding idiosyncratic risk. However, if investors systematically hold less than fully diversified portfolios and if they engage in narrow framing (Kahneman and Lovallo 1993, Barberis, Huang, and Thaler 2003) where they do not adopt a unified view of their financial portfolio, they are likely to demand compensation for the idiosyncratic risk in their equity portfolios. Consequently, the manner in which investors construct their equity portfolios is likely to influence asset prices. In this paper, we focus on the portfolio decisions of a representative group of more than 40, 000 investors at a large discount brokerage house 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 examine the volatility and risk characteristics of chosen portfolios and estimate the level of diversification in these portfolios. Our results indicate that a vast majority of individual investors in our sample are under-diversified. Even accounting for the likelihood we have selected a group of speculators, the magnitude of the idiosyncratic risk taken by investors in our sample is surprising. We estimate the economic costs of underdiversification, identify the determinants of this observed under-diversification, and examine if portfolio decisions of individual investors generate pervasive forces that influence asset prices. Consistent with the results from previous studies (Blume and Friend 1975, Kelly 1995, Odean 1999, Vissing-Jorgensen 1999, Barber and Odean 2000, Polkovnichenko 2003), we find that more than 25% of investor portfolios in our sample contain only 1 stock, more than 50% of them contain fewer than 3 stocks, and in any given month, only 5-10% of the portfolios contain more than 10 stocks. As a consequence, investor portfolios have extremely high volatility (more than 75% of investor portfolios have higher volatility than the market portfolio) and they exhibit worse risk-return trade-off than randomly constructed portfolios. The individual holding data allows us to do something previous authors studying individual accounts have not been able to do – directly calculate the variance and covariance of their equity holdings. This analysis allows us to decompose the level of diversification of a household into two components: (i) the risk reduction due to holding more than one security, and (ii) the risk reduction due to choosing imperfectly correlated stocks. We find positive evidence of the former and negative evidence of the latter.