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Do Portfolio Distortions Reflect Superior Information or Psychological Biases?

80 Pages Posted: 20 Jul 2009 Last revised: 20 Apr 2012

George M. Korniotis

University of Miami

Alok Kumar

University of Miami - School of Business Administration

Date Written: October 19, 2011

Abstract

The recent behavioral literature has shown that individual investors hold concentrated portfolios, trade excessively, and exhibit a preference for local stocks. These results are puzzling because in all three instances portfolio distortions could reflect either an informational advantage or psychological biases. In this study, using a demographics-based proxy for smartness, we show that the portfolio distortions of "smart" investors reflect an informational advantage that generate high risk-adjusted returns. In contrast, the distortions of "dumb" investors arise from psychological biases because they experience low risk-adjusted performance. When we do not condition on the level of portfolio distortions, the average net performance of smart investors is below passive benchmarks, but smart investors outperform dumb investors by about 3% annually on a risk-adjusted basis. Further, among investors with high portfolio distortions, smart investors outperform passive benchmarks by about 2% and the smart-dumb performance differential is over 5%. We also show that a portfolio of stocks with smart investor clientele outperforms the dumb clientele portfolio by about 3.50% annually. Taken together, these results suggest that both behavioral and information-based explanations for portfolio distortions are appropriate, but they apply to groups of dumb and smart investors, respectively.

Keywords: Individual investors, cognitive abilities, behavioral biases, diversification, active trading, local bias

JEL Classification: D14, G11, G14

Suggested Citation

Korniotis, George M. and Kumar, Alok, Do Portfolio Distortions Reflect Superior Information or Psychological Biases? (October 19, 2011). Journal of Financial and Quantitative Analysis (JFQA), Forthcoming. Available at SSRN: https://ssrn.com/abstract=1018668 or http://dx.doi.org/10.2139/ssrn.1018668

George M. Korniotis

University of Miami ( email )

P.O. Box 248094
Coral Gables, FL 33124-6552
United States
305-284-5728 (Phone)

Alok Kumar (Contact Author)

University of Miami - School of Business Administration ( email )

514 Jenkins Building
Department of Finance
Coral Gables, FL 33124-6552
United States
305-284-1882 (Phone)

HOME PAGE: http://moya.bus.miami.edu/~akumar

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