What is a Well-Diversified Investment Portfolio?

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, they tested the number of additional stocks needed to achieve a statistically important gain in diversification.²

The Evans and Archer study made the point that increasing diversification by purchasing additional stocks was not costless. Of course, when Professors Evans and Archer published their study in 1968, financial market transaction costs were far higher, and one had to be much more concerned with the cost of building a diversified portfolio.

At that time, one could argue that a lower number of stocks achieved a sufficiently well diversified portfolio on a cost-adjusted basis, because per unit transaction costs were so much higher than today.

Now, the ability of portfolio managers to pay attention to and make proper judgments on the business fundamentals, strategies, and performance of a very large number of potential portfolio holdings is a much more limiting factor in portfolio management than are trading costs.

These dramatic securities trading cost reductions, coupled with incredible increases in cost-effective computer and networking power over the intervening decades, have given rise to pervasive and highly sophisticated and automated portfolio analysis and trading activities among most professional money managers. Most individual investors just do not understand how “digitally deprived” they are - even though they also have much easier access to far more investment information through the Internet.

Individual investors simply do not understand that the availability of financial information through personal computers and the Internet only creates more of an illusion that they might beat the market that the reality that they really will. Individual investors are in direct competition with far more sophisticated professional traders and investment mutual fund and ETF managers - both actively-managed and passively-managed. In terms of net risk-adjusted investment performance, most individual investors are consistent and substantial losers. (See this article: What is the cost to individual investors of sub-optimal portfolio diversification?)

Investment portfolio self-assembly by individual investors versus investing in index mutual funds and index ETFs has become an increasingly and ridiculously naive proposition.

If you persist in the notion that you ought to buy individual stocks and bonds and/or you have a commissioned broker egging you on to buy individual stocks and bonds, you might want to read this revealing article entitled, “The Blow-Up” in Technology Review. Free registration is required to read this and other articles on the www.technologyreview.com website. You do not have to be an MIT alumnus/a to register for free.

This Technology Review article discusses the role of ‘quants’ or financial engineers in the 2007 summer meltdown in the subprime credit market. It is also instructive to individual investors on the capabilities of highly automated professional traders and investment fund money managers. This article might help you to understand how “digitally deprived” you are, if you attempt do-it-yourself investment portfolio self-assembly. Even though you now have access to far more investment information through the web, it is not the amount of investment information that you have access to that counts, but what you know how to and are able to do with it.

________________________________________
These related articles may also be useful to you:

• What is investment portfolio diversification?
• Investment securities markets do not pay you for the risks of holding individual common stocks and bonds
• Why is diversification valuable to individual investors?
• Is the average individual investor’s portfolio well diversified?
• What is the cost to individual investors of sub-optimal portfolio diversification?
• How do changes in common stock price volatility affect diversification?
• How does the size of the common stock risk premium affect diversification?
• How many mutual funds are needed for a well-diversified portfolio? – evidence
• How many mutual funds are needed for a well-diversified portfolio? – a commentary

1) John L. Evans and Stephen H. Archer. “Diversification and the Reduction of Dispersion: An Empirical Analysis.” Journal of Finance, Vol. 23, Issue 5: December 1968: p. 761-767
2) ibid, p. 766-767

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