Will and power: Investment diversification and systemic deviation from irrational risk

Abstract

Examining China’s stock market, mean variance is used to measure returns and risk and build an irrational risk-asset pricing model. The power of heterogeneous beliefs and risk-valuation deviation are found to affect capital asset pricing, presenting excessive fluctuations that neoclassical finance theory cannot easily explain. A diversified portfolio can disperse or aggregate irrational risk. Trading frequency and quantity reflect differences in investors’ rationality and reveal irrational risk effects. On that basis, regulatory tools and derivative products can be designed to build a rational risk anchor, prevent the systematic bias of irrational risk, and improve capital allocation.

Keywords:

• Irrational risk
• risk aggregation
• risk-valuation deviation
• behavioral finance
• equity premium

PUBLIC INTEREST STATEMENT

Is the capital market a paradise for value investment? Why does diversification also make it difficult to manage and control risk? Why is it that arbitrage often cannot correct extreme market behavior and price manipulation? Intravalue is the anchor of capital market stability. Sometimes, the market is effective, and risks can be dispersed through portfolio allocation and value exploration. However, the market is also a game of “will and power.” Owing to the disturbance of information, when the systematic deviation of irrational risk forms, it will lead to violent price fluctuations. Individuals’ responses to information should be consistent with the overall response of the market. The overall behavior of the transaction price, target, quantity, and timing are intuitive tools for monitoring irrational risks.

Acknowledgements

I would like to thank all those who helped me in the process of writing this paper.

First, I thank my students for their inspiration. Their doubts led me to think about how to incorporate irrational risks into the asset pricing model. I would also like to sincerely thank Professor Wang Taosheng and Professor Huang Mengqiao for their guidance and helpful comments on my manuscript. I am grateful for their assistance in helping me to complete this paper.

In addition, I thank the Hunan Provincial Department of Education and Hunan International Economic Risk Prevention and Management Research Base for their financial support (Innovation Platform Open Fund Project: 20K075). I also thank the Wind data terminal (www.wind.com.cn) for its data services, and I thank LetPub (www.letpub.com) for its linguistic assistance and expert pre-submission review.

Finally, I appreciate my family’s consideration and their great confidence in me over the years, especially my daughter Liu Xingyu for her assistance with data collection and processing. I also sincerely thank my friends who helped me to solve the problems I faced in the challenging process of writing this paper.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Additional information

Funding

This work was supported by the Hunan Provincial Department of Education, China (grant no. 20K075).

Notes on contributors

Yaping Liu

Yaping Liu is an associate professor in the Finance Department at Hunan International Economics University. He is mainly engaged in teaching and research on investment economics, behavioral finance and asset pricing, securities investment analysis, and other fields, particularly stock market anomalies. The present article pertains to key topics covered by the Hunan International Economic Risk Prevention and Management Research Base and Investment Research Institute, providing theoretical support for in-depth asset pricing preference, strong empirical justification, irrational risk monitoring, and irrational risk management.