“Investor Diversification and the Pricing of Idiosyncratic Risk” by Fangjian FU
Maria G. Schutte
Michigan Technology University
Singapore Management University
Theories predict that, due to investor under-diversification, idiosyncratic risk is positively priced in expected stock returns. Empirical studies based on different methodologies, however, yield mixed evidence. This study circumvents methodological issues and traces the pricing of idiosyncratic risk to its economic source – investor under-diversification. Assuming that institutional investors hold more diversified portfolios and thus care little about idiosyncratic risk in portfolio allocation relative to individual investors, we find that the positive relation between idiosyncratic risk and stock return is significantly stronger (weaker) in stocks that are held and traded more by individual (institutional) investors. In addition, the pricing of idiosyncratic risk weakens for stocks that experience significant increases in institutional holdings. Both the cross-sectional and time-series evidence supports the theory prediction that investor under-diversification drives the positive pricing of idiosyncratic risk.