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RFS Advance Access published online on January 29, 2007
Review of Financial Studies, 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 and Keith Vorkink
Brigham Young University and MIT

todd.mitton{at}byu.edu

kvorkink{at}mit.edu

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, 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.


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