Perhaps the most important trade-off for equity portfolio managers is between specialization and risk reduction. The fewer stocks they research and include in their portfolios, the better their understanding of the underlying companies and the better their chances of generating excess returns by focusing on their high-conviction positions. On the other hand, the fewer stocks they hold, the greater the likely volatility of the portfolio and the greater the risk of outsized losses.
So what is the right balance? As stocks are added to a portfolio, does volatility decrease equally in all types of stock portfolios? Or does it vary by style? When is the peak of diversification reached?
To find out, we compared the benefits of diversification across eight different portfolio styles: small cap vs large cap, value vs growth, dividend vs non-dividend, and US domestic vs international.
We constructed our portfolios from the upper and lower performance quartiles of NASDAQ and NYSE stocks corresponding to our different style factors. We constructed a random portfolio from a given number of equally weighted stocks in each style and calculated its volatility using the 15-year monthly returns from 2005 to 2020.
Then, after selecting another random portfolio of the same size, we performed the same procedure 100 times, averaging the volatility over all these iterations.
For each style cohort, we established an average volatility for each portfolio based on the number of stocks it contained.
What was the difference between large and small cap portfolios? The average volatility of a portfolio of 10 large-cap stocks was 20%. A more diversified large cap portfolio of 40 stocks only reduced volatility to 17%. Thus, adding 30 stocks reduced volatility by only 3 percentage points.
Maximum Diversification: Small Cap vs. Large Cap Portfolios
Adding equities to small cap portfolios, on the other hand, has brought much greater benefits. The average portfolio of 10 small-cap stocks had an average volatility of just over 32%, compared to 25% for the average portfolio of 40 small-cap stocks. Thus, 30 additional stocks provided more than twice as much diversification benefit to the small-cap portfolio as it did to its large-cap counterpart.
A similar story played out with dividend and non-dividend portfolios. While the average non-dividend portfolio increased from 10 to 40 stocks, volatility fell by 5 percentage points on average, from 26% to 21%. After diversifying the dividend portfolio from 10 to 40 stocks, volatility fell from 19% to 16%.
Maximum diversification: portfolios with dividends or without dividends
Growth versus value, however, showed a different relationship: there was not much variation in volatility as the number of stocks increased, and the reduction in risk was consistent across both cohorts.
Maximum diversification: value or growth portfolios
Finally, for portfolios comprised of domestic and international US stocks listed on NASDAQ and NYSE, adding stocks to the US portfolio reduced volatility slightly compared to increasing the number of stocks in the international portfolio.
Maximum diversification: US domestic vs. international portfolio
Overall, these results demonstrate that effective diversification depends on portfolio style. For large cap portfolios, there is little to be gained by diversifying beyond about 15 stocks. For small cap portfolios, maximum diversification is achieved with around 26 stocks. The same is true for non-dividend portfolios, while growth and value portfolios need roughly equal numbers of stocks to optimally reduce volatility.
So what’s the key takeaway? When it comes to maximum diversification of stock portfolios, one size does not fit all. And that’s something equity managers need to keep in mind when balancing the pros and cons of specialization versus risk reduction.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
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