Keywords

skewness preferences, underdiversified portfolios, idiosyncratic skewness

Abstract

We develop a one-period model of investor asset holdings where investors have heterogeneous preference for skewness. Introducing heterogeneous preference for skewness allows the model's investors, in equilibrium, to underdiversify. We find suppport for our model's three key implications using a dataset of 60,000 individual investor accounts. First, we document that the portfolio returns of underdiversified investors are substantially more positively skewed than those of diversified investors. Second, we show that the apparent mean-variance inefficiency of underdiversified investors can be largely explained by the fact that investors sacrifice mean-variance efficiency for higher skewness exposure. Furthermore, contrary to the asset-pricing predictions of models that incorporate return skewness in the context of full diversification, we show that idiosyncratic skewness, and not just coskewness, can impact equilibrium prices. Third, the underdiversification of investors does not appear to be coincidentally related to skewness. Stocks most often selected by underdiversified investors have substantially higher average skewness -- especially idiosyncratic skewness -- than stocks most often selected by diversified investors.

Original Publication Citation

“Equilibrium Underdiversification and the Preference for Skewness,” (with Todd Mitton), 2007, Review of Financial Studies, 20, 1255-1288.

Document Type

Peer-Reviewed Article

Publication Date

2005

Publisher

Review of Financial Studies

Language

English

College

Marriott School of Business

Department

Finance

University Standing at Time of Publication

Full Professor

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