Does Investor Recognition Predict Excess Returns

TLDR: In this paper, the authors investigated the impact of incomplete diversification and imperfect risk-sharing on asset returns and showed that the smaller a firm has, the larger the fraction of company idiosyncratic risk on average its investors have to carry, and the higher return they would demand for that.

Abstract: One of the main tenets of finance is diversification Investors choose their portfolios so as to diversify away their idiosyncratic risk In four essays included into this dissertation the implications of less than perfect diversification on investors’ performance and asset pricing are investigated In Essay I we examine one particular instance in which diversification may play a role in a non-portfolio type of investment: the IPO In an IPO, a set of potentially non-diversified investors – the existing shareholders – reduce their holdings of a company, listing the company and selling part of its shares Our contribution is to show how portfolio diversification of controlling investors in private companies affects the IPO process We demonstrate that companies sold by more diversified shareholders are less likely to be taken public, but when doing so they are priced more favourably In Essays II and III we investigate the impact of incomplete diversification and imperfect risk-sharing on asset returns Our argument is that the smaller shareholder base a firm has, the larger the fraction of company idiosyncratic risk on average its investors have to carry, and the higher return they would demand for that We demonstrate that there is a negative and significant relationship between companies’ shareholder base and stock returns as well as between changes in shareholder base and stock returns This effect is more pronounced for younger companies, but remains significant for seasoned companies as well Applying our analysis to corporate events we demonstrate that abnormal performance following the repurchase can be partially explained by the reduction in the shareholders base resulting from repurchase In Essay IV I investigate the motives behind one of the most puzzling examples of investors’ underdiversification – the local bias Contrary to the predictions of classical financial theories, investors on aggregate overweight stock of proximate companies in their portfolios I demonstrate that being placed in new community, individual investors not only soon become biased towards companies with establishments in this new locality, but they also obtain superior returns from these investments Investing into the local stocks, therefore, is to a large degree rational