Do the diversification choices of individual investors influence stock returns?

This paper shows that the diversification choices of individual investors influence stock returns. A zero-cost portfolio that takes a long (short) position in stocks with the least (most) diversified individual investor clientele generates an annual, risk-adjusted return of 5–9%. This spread reflects the combined effects of sentiment-induced mispricing, narrow risk framing, and asymmetric information, where the sentiment effect is the strongest. Furthermore, the influence on returns is stronger among smaller, low institutionally owned, and hard-to-arbitrage stocks. These results are robust to concerns about relatively short sample size, improper factor model specification, slow information diffusion, and high transactions costs.