Asset Pricing with Optimal Under-Diversification

58 Pages Posted: 15 Oct 2022 Last revised: 19 Jul 2023

See all articles by Vadim Elenev

Vadim Elenev

Johns Hopkins Carey Business School

Tim Landvoigt

University of Pennsylvania - The Wharton School; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 2 versions of this paper

Date Written: October 3, 2022

Abstract

We study sources and implications of undiversified portfolios in a production-based asset pricing model with financial frictions. Households take concentrated positions in a single firm exposed to idiosyncratic shocks because managerial effort requires equity stakes, and because investors gain private benefits from concentrated holdings. Matching data on returns and portfolios, we find that the marginal investor optimally holds 45% of their portfolio in a single firm, incentivizing managerial effort that accounts for 4% of aggregate output. Investors derive control benefits equivalent to 3% points of excess return, rationalizing low observed returns on undiversified holdings in the data. A counterfactual world of full diversification would feature higher risk free rates, lower risk premiums on fully diversified and concentrated assets, less capital accumulation, yet higher consumption and welfare. Exposure to undiversified firm risk can explain approximately 40% of the level and 20% of the volatility of the equity premium. A targeted subsidy that decreases diversification improves welfare by increasing managerial effort and reducing financial frictions.

Keywords: idiosyncratic risk, lack of diversification, equity premium, production-based asset pricing, financial frictions, rare disasters

JEL Classification: G12, G51, G32, E44, E21

Suggested Citation

Elenev, Vadim and Landvoigt, Tim, Asset Pricing with Optimal Under-Diversification (October 3, 2022). Jacobs Levy Equity Management Center for Quantitative Financial Research Paper, Available at SSRN: https://ssrn.com/abstract=4236861 or http://dx.doi.org/10.2139/ssrn.4236861

Vadim Elenev

Johns Hopkins Carey Business School ( email )

100 International Drive
Baltimore, MD 20036-1984
United States

Tim Landvoigt (Contact Author)

University of Pennsylvania - The Wharton School ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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