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Equilibrium Underdiversification and the Preference for Skewness

56 Pages Posted: 10 Dec 2004  

Todd Mitton

Brigham Young University - J. Willard and Alice S. Marriott School of Management

Keith Vorkink

Brigham Young University - J. Willard and Alice S. Marriott School of Management

Multiple version iconThere are 2 versions of this paper

Date Written: December 2004

Abstract

We develop a one-period model of investor asset holdings where investors have heterogeneous preference for skewness. Introducing heterogeneous preference for skewness allows the model's investors, in equilibrium, to underdiversify. We find suppport for our model's three key implications using a dataset of 60,000 individual investor accounts. First, we document that the portfolio returns of underdiversified investors are substantially more positively skewed than those of diversified investors. Second, we show that the apparent mean-variance inefficiency of underdiversified investors can be largely explained by the fact that investors sacrifice mean-variance efficiency for higher skewness exposure. Furthermore, contrary to the asset-pricing predictions of models that incorporate return skewness in the context of full diversification, we show that idiosyncratic skewness, and not just coskewness, can impact equilibrium prices. Third, the underdiversification of investors does not appear to be coincidentally related to skewness. Stocks most often selected by underdiversified investors have substantially higher average skewness -- especially idiosyncratic skewness -- than stocks most often selected by diversified investors.

JEL Classification: G11

Suggested Citation

Mitton, Todd and Vorkink, Keith, Equilibrium Underdiversification and the Preference for Skewness (December 2004). Available at SSRN: https://ssrn.com/abstract=630821 or http://dx.doi.org/10.2139/ssrn.630821

Todd Mitton

Brigham Young University - J. Willard and Alice S. Marriott School of Management ( email )

Provo, UT 84602
United States
801-422-1763 (Phone)

Keith Vorkink (Contact Author)

Brigham Young University - J. Willard and Alice S. Marriott School of Management ( email )

Provo, UT 84602
United States

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