<<– Continued from Part 1
In addition to showing that large numbers of additional stocks are required to achieve measurable improvements in diversification, the Evans and Archer study clarified other requirements for a well-diversified portfolio. The number of stocks selected for a highly diversified portfolio also depends on what one actually means by “the market.”
To achieve full diversification, as the scope of your definition of the “securities market” increases, you need to hold an increasing number of representative individual securities.
If one means the market for the largest U.S. companies, then the S&P 500 is one of several competing indexes and represents about 70% of total U.S. equity market capitalization. If one means the entire investable U.S. equities market, then the Wilshire 5000 is one of several that could be used. A global index would have many more stocks and would cover an even broader economic base. Therefore, the number of stocks to be well diversified would depend on what one means by the “market.” Within the meaning of finance literature, the full equity securities “market” portfolio is the global equities market and includes all investment styles and all countries.
In addition, to the numbers of different securities and their weighting, Evans and Archer indicated that you need to ensure that your securities selection process is random, if you wish to be fully diversified.
Your diversified investment portfolio construction methods should not biased toward one or another decision factor, such as being skewed toward a single industry or a subset of all industries.
Unless you buy the entire global market through an index fund or exchange-traded fund, your random selection of a subset of the whole market might be a method such as a “toss of the darts” at a capitalization-weighted stock page. This would mean that each security would have an equal chance of being selected for inclusion on a capitalization-weighted portfolio basis. Unless this random selection condition is met, the goal of constructing a highly-diversified portfolio would be disrupted, because you introduced a bias or skew through your selection methods.
Fundamental indexing investment product alternatives have received attention recently. Fundamental indexes select securities based on various company economic metrics rather than on a company’s securities market capitalization.
Concerning the use of capitalization weighting as the index benchmark for the full market and for full diversification, The Skilled Investor is well aware of the controversy percolating in [...]