A well-diversified portfolio contains a very large number of individual stocks and/or bonds that are selected without bias toward particular economic segments. A fully diversified portfolio will approximate the global publicly traded securities markets.
The question about diversification most frequently asked by individual investors is “how many stocks or bonds do I need to be well-diversified?” While the answer to this question is important, the caveats surrounding the answer are even more important. There are large numbers of scientific investment studies addressing the question of the number of stocks required to be well diversified. (See: Can a limited number of equities provide complete portfolio diversification? and How many common stocks are needed for a well-diversified portfolio?)
It is important that both the stock and bond portions of one’s portfolio be very well diversified. However, because stocks and bonds have very different characteristics, diversification considerations vary between these types of securities. Most of the scientific literature focuses on equities diversification, and there are relatively few studies on bond diversification. Because bond pricing is quite complex and bond markets transaction costs are relatively high for individual investors, the logic of investing through bond funds is extremely compelling. (See: Is it worth paying higher bond mutual fund management fees?)
The Skilled Investor has summarized several different diversification research papers, because of their points-of-view and educational value to individual investors. This article summarizes key observations of “Diversification and the Reduction of Dispersion: An Empirical Analysis” by Professors John Evans and Stephen Archer of the University of Washington is an early study on the number of stocks required to be well diversified.1 While this is an older study (1968), it is worth understanding, because Professors Evans and Archer went into some detail about what a well-diversified portfolio depends upon.
From the S&P 500 stock list, Professors Evans and Archer developed a model to test diversification using the 470 stocks that had complete data for the period 1958 to 1967. They randomly selected 60 different portfolios of 40 stocks each and compared these portfolios with the returns and price volatility of the S&P 500 index. They ran statistical tests to determine both the incremental value and costs of adding more stocks to a portfolio.
Concerning the number of stocks needed largely to eliminate unsystematic or company specific risk from a stock portfolio, they did not intend to come up with a single magic threshold number. Instead, [...]