Maxime Merli

An Optimal World Portfolio on the Eve of World War I: Was There a Bias to Investing in the New World Rather Than in Europe?

The geographical distributions of French and British foreign investment portfolios differ markedly before World War I. Did French portfolios favor European investments just as British portfolios favored “New World” assets? Should economic rationality have encouraged investors to invest widely in the “New World” rather than in Europe? Combining Modern Portfolio Theory and a new data set comprising assets listed on the Paris and London Stock Exchanges, we show that investing in the “New World” did not yield higher returns than investing in Europe. The “European preference” of the Paris Bourse and, by extension, of French investors was not inefficient.

Diversification, Gambling and Market Forces

Though simple and appealing, mean-variance portfolio choice theory does not describe actual diversification choices by investors, especially their propensity to gamble and the solvency constraints they face. Using 8 million trades realized by 90,000 individual investors, we show that diversification choices are in fact strongly driven by the skewness of returns, especially in bull markets, but also by the amount to be invested in risky assets. Increasing this amount by 10 % leads to increase by 3.8 % the number of stocks in investors’ portfolios, controlling for portfolio skewness. An important contribution of this paper is to show that the strength of the relationship between diversification and the skewness of returns is shaped by market forces. A strong negative relationship exists in bull markets but disappears in bear markets, a result not found in the literature. Our results survive several robustness checks, including controlling for individual heterogeneity and time-variability of stock price co-movements.In this paper, we first prove analytically that the skewness of returns of portfolios built with Arrow-Debreu securities decreases with diversification. Through simulations, we also show that this result remains true in a financial market with a finite number of states of nature. We then analyze the behavior of over 85,000 individual investors at a large brokerage house. Though the main determinant of underdiversification is the portfolio value we find that the skewness of returns remains significant in explaining diversification after controlling for this value. Moreover, we show that the decrease in skewness induced by diversification is essentially driven by the share of total variance of stock returns due to common factors. These findings extend those of Mitton and Vorkink (2007) and explain the variability over time of the relationship between skewness and diversification.