Diversifying? Volatility Matters More Than Size

A couple of researchers at financial advisory firm NDVR in Boston, Yin Chen and Roni Israelov, have come up with a new take on an age-old question for investors: How many stocks should you own for a properly diversified portfolio? The academic approach to finding an answer goes back to a 1968 Journal of Finance paper by John Evans and Stephen Archer that included a graph that you can find versions of in almost any introductory finance book and many personal finance articles today. They concluded there was little additional diversification benefit once you got beyond 10 or 15 stocks.

The conclusion by Evans and Archer, echoed in much of the subsequent work on the issue, has some implications for the investors that Chen and Israelov challenge:

  1. There’s little reason for index funds to go through the trouble of holding 500 or more stocks; they could achieve similar diversification with less expense holding 60 or 80 stocks or less
  2. Active managers should hold only their 20 or 30 best ideas rather than “deworsifying” into 60 or 80 holdings to reduce risk
  3. Ordinary retail investors can hold small handfuls of stocks efficiently, few enough so they can pay attention to each one

This chart shows portfolio volatility versus the number of randomly selected stocks in a portfolio. The orange dots represent actual data and the blue line is fitted to the data.