Idiosyncratic Risk and the Pricing of Poorly-Diversified Portfolios

This paper examines the role of idiosyncratic risk in explaining the cross-sectional variation of stock returns in the context of a set of size- and valuesorted portfolios.

Author(s):

Chris Brooks

University of Reading, Whiteknights

Xiafei Li

Nottingham University Business School

Joelle Miffre

EDHEC Business School

A vast body of literature has documented the value premium and the small firm effect as pervasive stylized facts in empirical asset pricing and yet research has been largely unable to provide entirely convincing explanations of these phenomena. This paper examines the role of idiosyncratic risk in explaining the cross-sectional variation of stock returns in the context of a set of size- and valuesorted portfolios. We show that the risk premium for bearing idiosyncratic risk varies inversely with the number of stocks in the portfolio, and for the worst diversified portfolios, remains statistically significant within multifactor models based on either macroeconomic or size and value factors. Our findings thus indicate conclusively that investors demand an additional return for bearing the idiosyncratic risk of poorly-diversified portfolios.

Type: Working paper
Date: le 29/06/2011
Research Cluster : Finance

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