How Much Is Too Much Diversification?
The Risk/Reward Tradeoff
Investors weigh two kinds of risk when considering investment returns: systemic risk (rist of an economic recession dragging down the stock market.) and fundamental risk (risk associated with a particular company or industry). By diversifying their capital across a broad range of securities, investors minimize fundamental risk.
How Much Is Too Much?
Theoretically, your exposure to fundamental risk lowers as you increase the number of equities in your portfolio. But at FAC, we believe there is such a thing as too much diversification.
Some products sold by major investment 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 is stretched so thin across the market, it cannot help but perform just as the market does—rising when it rises and falling when it falls.
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 of 3,290 securities. 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 offerings. With 30 holdings that are equally weighted and prudently re balanced, one stock may not make up more than 5% of the overall Model, and at 50 holdings, one stock will not make up more than 3%. This manageable number of individual holdings allows for the optimal balance between managing fundamental risk and providing negative correlation to the overall market. Even though FAC's Alpha Index methodology holds as many as 500 individual securities, it is however both Equal Weighted, (non-capitalization weighted) and Sector Weighted (over / under weighted in a particular sector thus adding Alpha over the static weightings of the originating index).
*E. J. Elton and M. J. Gruber, "Risk Reduction and Portfolio Size: An Analytic Solution," Journal of Business 50 (October 1977), pp. 415-37.