Does Income Risk Explain the Degree of Under-Diversification in Equity Portfolios?

Abstract

This paper demonstrates the degree of under-diversification in equity portfolios can be explained by income risk (or other forms of risks faced by the household; e.g., unemployment risk). We present a model of investor diversification behavior in order to provide a framework by which to evaluate our empirical evidence on the benefit of diversification on: (1) eliminating the unsystematic risk in a portfolio, and (2) smoothing fluctuated labor income. When the benefit of diversification on both is at the same rate, households own well diversified portfolios; when the benefit on the latter exceeds the former, households possess under-diversified portfolios. In addition, the under-diversification pattern varies geographically, which relates to the income and unemployment risks. Our results have implications on the narrow framing literature, where we find most households have a broad framing when they try to optimize. Collectively, we show that people take an overall view of the risks they face when they make financial decisions.