Do the Diversification Choices of Individual Investors Influence Stock Returns?

Abstract

This paper shows that the diversification choices of individual investors influence stock returns. A zero-cost portfolio that takes a long (short) position in stocks with the least (most) diversified individual investor clientele generates an annual, risk-adjusted return of 5-9%. This spread reflects the combined effects of sentiment induced mispricing, narrow risk framing, and asymmetric information, where the sentiment effect is the strongest. Furthermore, the influence on returns is stronger among smaller, low institutionally owned, and hard-to-arbitrage stocks. These results are robust to concerns about relatively short sample size, improper factor model specification, slow information diffusion, and high transaction costs.