We study the effects of investor protection on stock returns and portfolio allocation decisions. In our theoretical model, if investor protection is weak, wealthy investors have an incentive to become controlling shareholders. In equilibrium, the stock price reflects the demand from both controlling shareholders and portfolio investors. Due to the high demand from controlling shareholders, the price of weak corporate governance stocks is not low enough to fully discount the extraction of private benefits. Thus, stocks have lower expected returns when investor protection is weak. This has implications for domestic and foreign investors’ stockholdings. In particular, we show that portfolio investors’ participation in the domestic stock market and home equity bias are positively related to investor protection and provide original evidence in their support.
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