The Demand for Diversification in Incomplete Markets

54 Pages Posted: 15 Aug 2016

See all articles by Rajnish Mehra

Rajnish Mehra

Arizona State University (ASU) - W.P Carey School of Business, Department of Economics; National Bureau of Economic Research (NBER)

Sunil Wahal

Arizona State University (ASU) - Finance Department

Daruo Xie

Australian National University (ANU)

Date Written: May 12, 2016

Abstract

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

Suggested Citation

Mehra, Rajnish and Wahal, Sunil and Xie, Daruo, The Demand for Diversification in Incomplete Markets (May 12, 2016). Available at SSRN: https://ssrn.com/abstract=2820850

Rajnish Mehra

Arizona State University (ASU) - W.P Carey School of Business, Department of Economics ( email )

Tempe, AZ 85287-3806
United States
480 965 6335 (Phone)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Sunil Wahal

Arizona State University (ASU) - Finance Department ( email )

W. P. Carey School of Business
PO Box 873906
Tempe, AZ 85287-3906
United States

Daruo Xie (Contact Author)

Australian National University (ANU) ( email )

Canberra, Australian Capital Territory 2601
Australia

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