“Many people believe that diversification beyond 10 or 20 securities is superfluous despite clear research indicating that the opposite is in fact the case,” says an article in the July issue of the AAII Journal.
The article defines different types risk (including firm risk, industry risk and market risk), then cites past research findings and a “history of erroneous reasoning regarding adequate portfolio size.” It outlines the findings of an AAII study to “address the issue of how large a portfolio should be to achieve adequate diversification” that included all publicly-traded equities over the period between January 1960 and December 2001.
The study found that, for investors with smaller stock portfolios (less than $100K), “it is typically not reasonable to try to hold the large number of stocks, 100 or more, that removes ‘enough’ diversifiable risk.” These investors, the article suggests, would benefit from using “very broadly diversified, low-expense mutual funds or exchange-traded funds.” For investors with larger equity portfolios, however, “wherein the benefits of individual stock ownership exceed the costs, the implication is to hold a very large number of stocks,” with the precise number dependent on portfolio size, trading costs, tax bracket and other factors.
The article concludes with suggestions regarding how to build a well-diversified portfolio:
- Stocks should be market cap-weighted.
- The larger the firm, “the more important that it be included in the portfolio.”
- “A portfolio with nearly equal weights will not be well-diversified relative to the overall market regardless of how many stocks are selected.”
- Stocks should be selected at random, or with “careful and purposeful diversification, such as by selecting stocks from a variety of industries and balancing with respect to effects such as style (e.g., value or growth) and size. “Our experience,” the article says, “is that many investors select poorly diversified portfolios because they deliberately select a particular type of stock (e.g., low price-earnings ratios) or because they subconsciously are drawn to particular types of stocks (e.g., firms with consumer products that have familiar sounding names).
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