Review of Finance Advance Access originally published online on March 28, 2008
Review of Finance 2008 12(3):433-463; doi:10.1093/rof/rfn005
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Equity Portfolio Diversification*
1 School of Management, Yale University
2 McCombs School of Business, University of Texas at Austin
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.
JEL Classification: G11, G12
* We would like to thank two anonymous referees, Mary Bange, Brad Barber, Robert Battalio, John Campbell, Peng Chen, Shane Corwin, Simon Gervais, Hans Heidle, George Korniotis, Sonya Lim, Terrance Odean, Marco Pagano (the editor), Jim Poterba, K. Geert Rouwenhorst, Paul Schultz, Mark Seasholes, Ann Sherman, Meir Statman, Margaret Zhu, Ning Zhu and seminar participants at 2003 University of Pennsylvania Conference on Household Portfolio-Choice and Financial Decision-Making, 2004 DePaul Behavioral Finance Conference, and University of Notre Dame for helpful discussions and valuable comments. We would also like to thank Itamar Simonson for making the investor data available to us, and Brad Barber and Terrance Odean for answering numerous questions about the database. We are responsible for all remaining errors and omissions. This paper also circulated as NBER Working Paper # 8686 and under the title "Why Do Individual Investors Hold Under-Diversified Portfolios?".