Preferred Risk Habitat of Individual Investors

Abstract

The preferred risk habitat hypothesis, introduced here, is that individual investors select stocks whose volatilities are commensurate with their risk aversion. The data, 1995-2000 holdings of over 20,000 clients at a large German broker, are consistent with the predictions of the hypothesis: the returns of stocks within each portfolio have remarkably similar volatilities, when stocks are sold they are replaced by stocks of similar volatilities, and the more risk averse customers indeed hold less volatile stocks. Greater volatility specialization is associated with lower Sharpe ratios, primarily because more specialized investors hold fewer stocks and thereby expose themselves to more unsystematic risk.

Keywords: portfolio choice, narrow framing, investor behavior, volatility, risk aversion, diversification

JEL Classification: G11, D14, D81