Peak Diversification: How many stocks bring the best diversification to an equity portfolio?

Probably the biggest tradeoff for equity portfolio managers is between specialization and risk reduction. The less stocks they research and incorporate into their portfolios, the better their understanding of the underlying companies and the more likely they are to earn additional returns by focusing on their high-profile positions. Conversely, the less stock they hold, the greater the volatility of the portfolio and the greater the likelihood of external losses.

So what is the right balance? Since stock is added to a portfolio, does all equity portfolio type reduce volatility in the same way? Or does it change depending on the style? At what time is maximum diversity achieved?

To find out, we compared the advantages of diversification into eight different portfolio styles: small caps vs. large caps, value vs. growth, dividends vs. non-dividends, and U.S. domestic vs. international.

We have built our portfolio from the top and bottom performance quartiles of NASDAQ and NYSE stocks according to our different style factors. We created a random portfolio from a certain number of equally heavy stocks in each style and calculated its volatility using monthly returns over 15 years from 2005 to 2020.

Then, after selecting another random portfolio of the same size, we conducted the same procedure 100 times, averaging the volatility across all these repetitions.

For each style group, we have come up with an average volatility for each portfolio based on the number of stocks it has.

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What was the difference between a large-cap and a small-cap portfolio? The average volatility of the large-cap 10-stock portfolio was 20%. A more diversified large-cap portfolio of 40 stocks has only reduced volatility by 17%. So adding 30 stocks reduces volatility by only 3 percentage points.

Peak Diversification: Small-Cap vs. Large-Cap Portfolio

Charting Diversification Benefit Diversification Small-Cap vs. Large-Caps

On the other hand, adding stock to a small-cap portfolio has many advantages. The average small-cap 10-stock portfolio had an average volatility of more than 32% compared to 25% for the average small-cap 40-stock portfolio. So more than 30 stocks have come up with double the advantage in a small-cap portfolio compared to its large-cap portion.

A similar story was published with dividend and non-dividend portfolios. If the average non-dividend portfolio remains 10 to 40 stocks, volatility averages a decrease of 5% points, from 26% to 21%. After diversifying the dividend portfolio from 10 to 40 stocks, volatility has dropped from 19% to 16%.

Peak Diversification: Dividends vs. Non-Dividend Portfolio

Showing chart peak diversification: dividends vs. non-dividend portfolios

Growth versus value, however, showed a different relationship: there was not much variation in volatility as the number of stocks increased and risk reduction was in both groups.

Maximum Variety: Value vs. Increased Portfolio

Chart Peak Diversification: Value vs. Growth Portfolio

Finally, for portfolios consisting of U.S. domestic and international stocks listed on the NASDAQ and NYSE, volatility is somewhat reduced by adding more stocks to the U.S. portfolio than an increase in the number of stocks in the international portfolio.

Top Diversity: US Domestic vs. International Portfolio

All in all, these results show that effective variability depends on the portfolio style. For large-cap portfolios, 15 stocks or more are rarely available with diversification. For small-cap portfolios, maximum diversity is achieved with about 26 stocks. The same applies to non-dividend portfolios, when growth and price portfolios need a fairly equal number of stocks to decrease volatilely.

So what is acceptable? When it comes to maximizing diversity in an equity portfolio, one size fits all. And equity managers should keep in mind the benefits of specialization versus risk reduction and the balance of liabilities.

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All posts are the author’s opinion. As such, they should not be construed as investment advice, or the opinions expressed must not reflect the views of the CFA Institute or the author’s employer.

Image Credit: © Getty Images / Abstract Aerial Art

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Eden Eccles

Eden Eccles is currently in his final semester at George Mason University and will complete a bachelor’s degree in finance. In his senior year, he served as vice president of the Risk Committee of the Student Managed Investment Fund where he can pursue his passion for portfolio management and data analysis. Upon graduation, Eccles will work as a finance and value analyst for the Northrop Grumman Space System.

Coffee in Lindsay

Lindsay Coffee is a current freshman at George Mason University. He majored in economics at Honors College and undergraduate school of business and is young in mathematics. He is a member of George Mason’s Social Impact Fellow program and the Division I Lacrosse team. After graduating, he hopes to earn a master’s degree in financial mathematics and work in the field of investment banking.

Derek Horstmeyer

Derek Horstmeyer is a professor at George Mason University School of Business, an expert on exchange-traded funds (ETFs) and mutual fund performance. He currently serves as the new director of financial planning and asset management at George Mason and established the first student-led investment fund at GMU.

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