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RFS Advance Access originally published online on January 29, 2007
Review of Financial Studies 2007 20(4):1255-1288; doi:10.1093/revfin/hhm011
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Copyright © The Author 2007. Published by Oxford University Press on behalf of The Society for Financial Studies.

Equilibrium Underdiversification and the Preference for Skewness

Todd Mitton
Brigham Young University

Keith Vorkink
MIT and Brigham Young University

Address correspondence to Todd Mitton, Marriott School, Brigham Young University, Provo, UT, 84602, or e-mail: todd.mitton{at}byu.edu

JEL: G11, G12


  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 support 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, 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.

We are grateful to Terry Odean for providing the retail investor dataset. We appreciate the helpful comments of Jim Brau, Campbell Harvey, Joel Hasbrouck, Francis Longstaff, Grant McQueen, Terry Odean, Meir Statman, Maurry Tamarkin, Steve Thorley, and an anonymous referee. We acknowledge financial support from the Harold F. and Madelyn Ruth Silver Fund and from Intel Corporation and research support from Greg Adams. We also acknowledge our Ford Research Fellowships.


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