Investor Diversification and the Pricing of Idiosyncratic Risk

• Main Author: FU, Fangjian
• Format: text
• Language: English
• Published: Institutional Knowledge at Singapore Management University 2010
• Subjects: Idiosyncratic risk; Stock returns; Diversification; Institutional investors; Finance and Financial Management; Portfolio and Security Analysis
• Online Access: https://ink.library.smu.edu.sg/lkcsb_research/3042; https://ink.library.smu.edu.sg/context/lkcsb_research/article/4041/viewcontent/FuFJ2010InvestorDiversificationAndThePricingOfIdiosyncraticRisk.pdf
• Institution: Singapore Management University

Theories predict that, due to investor under-diversification, idiosyncratic risk is positively priced in expected stock returns. Empirical studies based on various methodologies yield mixed evidence. This study circumvents the debate on methodological issues and traces the pricing of idiosyncratic risk to its economic source – investor under-diversification. Assuming that institutional investors tend to hold more diversified portfolios and thus care little about idiosyncratic risk relative to individual investors, we find that the positive relation between idiosyncratic risk and stock returns is significantly stronger (weaker) in stocks that are held and traded more by individual (institutional) investors. In addition, the pricing of idiosyncratic risk becomes weaker over time as institutional investors become more dominant in the US equity market.