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Han et al. 2021 documented something relating to the "under diversification puzzle":

Standard explanations for under diversification include hedging motives and heterogeneous preferences, but several studies highlight the limitations of these explanations

From Statman, 2004, I understand that "under diversification puzzle" is normally, we should hold a portfolio of around 300 stocks but in U.S, the average investor hold is only 3 or 4 stocks.

I understand that "hedging motives" is that risk aversion, meaning investors need to buy some stocks to reduce the risk of the portfolio. "heterogeneous preference" is that each individual investor has their own risk preference. However, given the understanding above, I cannot understand why we can use "hedging motives" and "heterogeneous preferences" to explain the "underdiversification puzzle"

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    $\begingroup$ Hi Louise, i remember Mitton, Boyer and Vorkink wrote an explanation by setting up a model on how heterogeneity in preferences might impact diversification decisions: jstor.org/stable/4494802... Let me know if this is helpful, then i post a full-fledged answer :-) $\endgroup$
    – T123
    Nov 2, 2021 at 11:09
  • $\begingroup$ Dear @T123J, it would be a big help that you can post an answer that can benefit me and other readers who may have the same problems with me :D. Thanks a heap $\endgroup$ Nov 2, 2021 at 11:15
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    $\begingroup$ Consumer Hedging motives for investment were discussed years ago by R.C.Merton. A (contrived) example is an automobile owner who could buy Exxon stock to hedge against increases in price of gasoline. $\endgroup$
    – nbbo2
    Nov 2, 2021 at 11:43
  • $\begingroup$ @noob2, if they buy more stocks to hedge, it would increase the number of stocks being held, leading to better diversification rather than underdiversification? $\endgroup$ Nov 2, 2021 at 13:23
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    $\begingroup$ Not necessarily. If they only care about hedging, they could end up with a very strange portfolio, 100% XOM stock, or to hedge inflation 100% Gold. Very undiversified. $\endgroup$
    – nbbo2
    Nov 3, 2021 at 16:22

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