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Solvency Constraint, Underdiversification, and Idiosyncratic Risks

Published online by Cambridge University Press:  13 May 2014

Hong Liu
Hong Liu*
Affiliation:
[email protected], Olin Business School, Washington University in St. Louis, 1 Brookings Dr, St. Louis, MO 63130 and China Academy of Financial Research (CAFR).
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Abstract

Contrary to the prediction of the standard portfolio diversification theory, many investors place a large fraction of their stock investment in a small number of stocks. I show that underdiversification may be caused by solvency requirements. My model predicts that for quite general preferences and return distributions: (1) underdiversification decreases in discretionary wealth; and (2) expected return and covariance determine which stocks to invest in, but variance, higher moments, and Sharpe ratio do not matter for this choice. In addition, a less-diversified stock portfolio has a higher expected return, a higher volatility, and a higher skewness, and idiosyncratic risks are priced.

Type
Research Articles
Information
Journal of Financial and Quantitative Analysis , Volume 49 , Issue 2 , April 2014 , pp. 409 - 430
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2014 

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