Portfolio Underdiversification Research Articles

Why does junior put all his eggs in one basket? A potential rational explanation for holding concentrated portfolios

Empirical studies of household portfolios show that young households, with little financial wealth, hold underdiversified portfolios that are concentrated in a small number of assets, a fact often attributed to behavioral biases. We present a potential rational alternative: we show that investors with little financial wealth, who receive labor income, rationally limit the number of assets they invest in when faced with financial constraints such as margin requirements and restrictions on borrowing. We provide theoretical and numerical support for our results and identify the ratio of financial wealth to labor income as a useful control variable for household portfolio studies.

Information immobility, industry concentration, and institutional investors’ performance

This paper examines foreign institutional investors’ portfolio allocation and performance in US securities. We test how information immobility, proxied by information barriers between the investors’ home markets and the US, influences portfolio strategies. Consistent with theoretical predictions, foreign institutional investors’ total investment in the US is negatively related to information immobility. Similarly, information immobility is a significant driver of portfolio under-diversification across industries. Industry concentration has declined over time, consistent with declining search costs. Industry-concentrated portfolios outperform more diversified portfolios for both foreign and US institutional investors. Concentration especially helps institutional investors with the easiest access to information.

Volatility Management and Wealth Creation: A Long-Term Perspective

Investors may not understand the wealth-destroying implications of their investment decisions, because of the deleterious effect of volatility of returns on wealth creation. Managing the volatility of returns is integral to creating long-term wealth. The methodology presented quantifies the single-period risk-and-return tradeoff that investors need to be aware of to create long-term wealth. Practitioners can use it as a tool to educate clients about the wealth-creating benefits of diversification. Economic sector return data is used to demonstrate that underdiversified portfolios, as opposed to diversified portfolios, inhibit long-term wealth creation, because of the volatility drag associated with underdiversified portfolios. <b>TOPICS:</b>Wealth management, risk management, portfolio construction

Information Acquisition, International Under-Diversification and Portfolio Performance of Institutional Investors

We test whether 1) institutional investors with concentrated international holdings outperform internationally diversified investors, and 2) foreign investors with information advantage, measured by cultural and geographic proximity to the target market, outperform other foreign investors. Using the United States as a target market, we document that investors concentrated in US securities do not outperform other investors. This result contradicts the idea that internationally under-diversified portfolios are mean-variance efficient due to the benefits of economies of scale and specialization. However, cultural similarity and geographic proximity to the US enhance investors’ performance in US securities.

Information Immobility, Industry Concentration, and Institutional Investors’ Performance

This paper examines institutions’ portfolio allocation and performance in US securities. We test how information immobility, proxied by market correlation and cultural and geographical distance between the investors’ home markets and the US, influences portfolio strategies. Consistent with theoretical predictions, foreign institutions’ total investment in the US is negatively related to information immobility. In addition, information immobility is a significant driver of portfolio under-diversification, measured as industry concentration of portfolios. Similar to a sample of US institutions, industry concentrated foreign institutions outperform industry diversified foreign institutions in US securities. Concentration especially helps institutions with the most difficult access to information.

Information Immobility, Industry Concentration, and Institutional Investors’ Performance

This paper examines foreign institutional investors’ portfolio allocation and performance in US securities. We test how information immobility, proxied by cultural and geographical distance between the investors’ home markets and the US, influences portfolio strategies. Consistent with theoretical predictions, foreign institutional investors’ total investment in the US is negatively related to information immobility. Similarly, information immobility is a significant driver of portfolio under-diversification across industries. Industry concentration has declined over time, consistent with declining search costs. Industry-concentrated portfolios outperform more diversified portfolios for both foreign and US institutional investors. Concentration especially helps institutional investors with the easiest access to information.

Fear of the Unknown: Familiarity and Economic Decisions*

Evidence indicates that people fear change and the unknown. We offer a model of familiarity bias in which individuals focus on adverse scenarios in evaluating defections from the status quo. The model explains the endowment effect, portfolio underdiversification, home and local biases. Equilibrium stock prices reflect an unfamiliarity premium. In an international setting, our model implies that the absolute pricing error of the standard CAPM is positively correlated with the amount of home bias. It also predicts that a modified CAPM holds wherein the market portfolio is replaced with a portfolio of the stock holdings of investors not subject to familiarity bias.

Is Idiosyncratic Risk Priced? The International Evidence

We examine the relation between expected returns and idiosyncratic risk across 44 countries from 1980 to 2007. Theory suggests that expected returns are unrelated to idiosyncratic risk if investors hold fully-diversified portfolios, and positively related if investors hold under-diversified portfolios. The empirical evidence to date has been decidedly mixed. In this study, we apply Fu’s (2009) EGARCH model to an international setting and provide supportive evidence for a positive and significant relation between expected returns and idiosyncratic risk – suggesting that the typical investor holds an under-diversified portfolio. Our international dataset also allows us to examine the relation between country-level determinants of investor under diversification and idiosyncratic risk premiums. We find that such risk premiums are larger in markets with lower investor wealth and higher investor risk tolerance. We also find that investor characteristics are more important determinants of the size of the idiosyncratic risk premium than are information and transaction costs. Our study makes two primary contributions. First, we verify the existence of a positive risk premium for idiosyncratic volatility using over seven million observations from 58,000 stocks across 44 markets. Second, and perhaps more important, we show that idiosyncratic risk premiums are directly attributable to investor under-diversification.

Asset Selection and Under-Diversification with Financial Constraints and Income: Implications for Household Portfolio Studies

Empirical Studies of household portfolios have shown that young and relatively poor households hold under-diversified portfolios that are concentrated in a small number of assets, a fact often attributed to various behavioral biases. We present a model in which relatively poor investors, i.e., investors with a little financial wealth, who receives labor income and have access to multiple risky assets rationally limit the number assets they invest in when faced with financial constraints such as margin requirements and restrictions on borrowing. We provide both theoretical and numerical support for our results and show, in an example calibrated to returns of five industry portfolios from 1927-2004, that while older investors optimally hold diversified portfolios, younger investors prefer portfolios that are concentrated in high-tech stocks that offer higher expected returns. Our results suggest that the ratio of financial wealth to labor income would be a useful control variable in household portfolio studies.

Equity Portfolio Diversification*

This study shows that U.S. individual investors hold under-diversified portfolios, where the level of under-diversification is greater among younger, low-income, less-educated, and less-sophisticated investors. The level of under-diversification is also correlated with investment choices that are consistent with over-confidence, trend-following behavior, and local bias. Furthermore, investors who over-weight stocks with higher volatility and higher skewness are less diversified. In contrast, there is little evidence that portfolio size or transaction costs constrains diversification. Under-diversification is costly to most investors, but a small subset of investors under-diversify because of superior information. Copyright 2008, Oxford University Press.

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

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.

Fear of the Unknown: Familiarity and Economic Decisions

Evidence indicates that people fear change and the unknown. We offer a model of familiarity bias in which individuals focus on adverse scenarios in evaluating defections from the status quo. The model explains the endowment effect, portfolio underdiversification, home and local biases. Equilibrium stock prices reflect an unfamiliarity premium. In an international setting, our model implies that the absolute pricing error of the standard CAPM is positively correlated with the amount of home bias. It also predicts that a modified CAPM holds wherein the market portfolio is replaced with a portfolio of the stock holdings of investors not subject to familiarity bias.

Equity Portfolio Diversification

This study shows that U.S. individual investors hold under-diversified portfolios, where the level of under-diversification is greater among younger, low-income, less-educated, and less-sophisticated investors. The level of under-diversification is also correlated with investment choices that are consistent with over-confidence, trend-following behavior, and local bias. Furthermore, investors who over-weight stocks with higher volatility and higher skewness are less diversified. In contrast, there is little evidence that portfolio size or transaction costs constrains diversification. Under-diversification is costly to most investors, but a small subset of investors under-diversify because of superior information.

New Venture Opportunity Cost of Capital and Financial Contracting

Investments in new ventures involve financial contracts between an entrepreneur and outside investors. Investors, such as venture capital firms, represent well-diversified investors. In contrast, the entrepreneur must commit a substantial fraction of human and financial capital to the venture. Consequently, the entrepreneur's required rate of return depends on total risk, in the context of the entrepreneur’s other assets. In this paper, we use the Capital Asset Pricing Model as an approximation of the asset pricing model used by well-diversified investors. Accordingly, the entrepreneur faces the risk-return tradeoff of the CAPM as the opportunity cost of holding an under-diversified portfolio that includes investment in the venture. We model the required rate of return of the entrepreneur, assuming investment in the venture is one of two assets in the portfolio and that the other is the market portfolio. We explore opportunities for value creation when the parties to a financial contract have different costs of bearing risk. We also present empirical data on factors relevant to new venture cost of capital estimation.