The Demand for Diversification in Incomplete Markets
54 Pages Posted: 15 Aug 2016
Date Written: May 12, 2016
Endogenous diversification in a market with incomplete information generates a state-dependent premium for bearing idiosyncratic risk because time series variation in average idiosyncratic risk affects the disutility of under-diversification. This idea delivers a metric that maps the marginal disutility of under-diversification to the covariance of idiosyncratic risk with average idiosyncratic risk. The metric helps explain the cross-section of returns in the US between 1973 and 2014, especially in periods of low average idiosyncratic risk. In such periods, portfolios tests generate intercepts from factor models that are economically large, and present in both small and large capitalization stocks. We observe similarly large intercepts in markets outside the US, particularly in large stocks.
Keywords: diversification, cross-section of returns
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