How Much Is Too Much Diversification?
The Risk/Reward Tradeoff
Generally speaking, investors must accept greater risk for potentially higher returns. This is known as the risk/reward tradeoff. However, it's important to remember that there are two kinds of risk: systemic risk, which is the risk of an economic recession dragging down the entire stock market, and fundamental risk, which is the risk associated with a particular company or industry. Diversification is a strategy whereby investors manage fundamental risk by spreading their capital across a broad range of securities, so that losses in one asset or sector may be offset by gains in another.
How Much Is Too Much?
Theoretically, the more equities you hold in your portfolio, the lower your exposure to fundamental risk. But at FAC, we believe there is such a thing as too much diversification. Some products sold by the major Wall Street firms hold billions of dollars in assets. In order to diversify such an enormous amount of capital, they may purchase thousands of securities, making their product so diversified that it actually mirrors the market or index it is attempting to outperform. The product actually becomes over-diversified, or positively correlated to the market. When you consider the additional transaction and management costs involved in holding so many different securities, it becomes clear that this strategy is also more expensive to the individual investor.
Where Is the Sweet Spot?
A landmark study conducted by E. J. Elton and M. J. Gruber before the revolution of online investing found that 20 to 30 securities within a portfolio offered the optimal level of diversification. More recent research suggests that investors taking advantage of the low transaction costs afforded by online brokers can optimize their portfolios by holding closer to 50 stocks.
The following table summarizes the results of Elton and Gruber's* empirical study. They took a population of 3,290 securities available for possible inclusion in a portfolio and considered the average risk. After choosing n-asset portfolios — with equal amounts held in each included asset — for various values of n, they found that more gains from diversification came from portfolios with 30 to 50 holdings.
Number of Stocks in Portfolio
Average Standard Deviation of Annual Portfolio Returns
Ratio of Portfolio Standard Deviation to Standard Deviation of a Single Stock
Diversification in FAC's Models
Based on this and other research, FAC selects between 30 to 50 individual securities for inclusion in its various Models. At 30 holdings that are equally weighted and prudently rebalanced, one stock will not make up more than 2.85% of the overall Model, and at 50 holdings, one stock will not make up more than 2%. This manageable number of individual holdings allows for the optimal balance between 1) managing fundamental risk and 2) providing negative correlation to the overall market.
*E. J. Elton and M. J. Gruber, "Risk Reduction and Portfolio Size: An Analytic Solution," Journal of Business 50 (October 1977), pp. 415-37.