DP6532 Preferred Risk Habitat of Individual Investors

Author(s): Daniel Dorn, Gur Huberman
Publication Date: October 2007
Keyword(s): preferred risk habitat, risk, risk aversion, stock portfolio, volatility
JEL(s): G10
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=6532

The preferred risk habitat hypothesis, introduced here, is that individual investors select stocks with volatilities commensurate with their risk aversion; more risk-averse individuals pick lower-volatility stocks. The investors' portfolio perspective overlooks return correlations. The data, 1995-2000 holdings of over 20,000 customers of a German broker, are consistent with the predictions of the hypothesis: the portfolios contain highly similar stocks in terms of volatility, when stocks are sold they are replaced by stocks of similar volatilities, and the more risk averse customers indeed hold less volatile stocks. Cross-sectionally, the more risk averse investors also have a stronger tendency to invest in mutual funds. Major improvements in diversification are concentrated during periods when investors add money to their account.