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Conclusion to: What Is a Well-Diversified Investment Portfolio?

<<– Continued from Part 1

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Eva in the Stocks by clurr
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 the industry and in financial journals about the possible advantages and disadvantages of market capitalization weighting of mutual funds and ETFs. Supposedly “new” fundamental indexing methods are based upon various measures of a company’s economic impact, such as revenues, dividends, book value, number of employees, etc.

A detailed analysis of this “market capitalization” versus business or fundamental indexing metrics dispute is beyond the scope of this diversification article. In short, however, well-constructed statistical investment analyses of the past several decades have shown that other factors affect securities prices, in addition to the economic risk factors that affect the overall markets. In particular, a “value stock” versus “growth stock” factor seems to exist.

In general, over much longer periods value stocks tend to out-perform growth stocks. However, for shorter periods there is a cyclical and unpredictable ebb and flow, concerning when one or the other strategy produces superior returns.

Whether you should have a “value” versus “growth” emphasis in your investment portfolio selection has been debated for much longer than this more recent debate about “fundamental” indexing. In fact, fundamental indexing might just primarily be a better method to introduce a “value tilt” into an investment program.

However, the higher current fee structure associated with fundamental indexing investment vehicles on the market could nullify its potential risk-adjusted return advantage – partially or fully. There are very broadly diversified capitalization weighted market index funds and ETFs available with annual management fees of only .1% and total costs around .2% annually. [Since decimal points are sometimes hard to read on the web, note that these are “point one” and “point two” percent or one-tenth and two-tenths of one percentage point.]

Fundamentally indexed products have annual management fees that typically are .5% to 1.0% higher – not including other less visible costs, such as incremental trading expenses. You have to be very confident in your convictions about the superiority of fundamentally indexed funds to choose them over much cheaper capitalization weighted index mutual funds and ETFs.

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These related articles may also be useful to you:

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
3) [ICI 2007] Investment Company Institute. “2007 Mutual Fund Fact Book.” Table 1, p. 93, http://www.icifactbook.org/ Accessed 10-25-07

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