Equity Portfolio Diversification

Abstract

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 diversification is constrained by portfolio size or transaction costs. Under-diversification is costly to most investors, except for a small subset of investors who under-diversify because of superior information.

Keywords: Individual investors, diversification, local bias, over-confidence, trend-following behavior

JEL Classification: G11, G12