Total Risk Systematic Risk Unsystematic Risk
Diversification reduces the unsystematic risk of a portfolio. Remember that on average, the negative stock-specific surprises affecting companies in a diversified portfolio will be offset by positive surprises.
|
Number of Stocks in Portfolio |
Average Standard Deviation of Annual Portfolio Returns |
Ratio of Portfolio Standard Deviation of a Single Stock |
|
1 |
49.24% |
100% |
|
10 |
23.93% |
49% |
|
50 |
20.20% |
41% |
|
100 |
19.69% |
40% |
|
300 |
19.34% |
39% |
|
500 |
19.27% |
39% |
|
1000 |
19.21% |
39% |
Table 2-7 summarizes the results of a study8 performed by Meir Statman in 1987. The study looked at randomly grouped portfolios of stocks of various sizes to determine the marginal amount of diversification achieved by adding additional stocks to a portfolio. Volatility of individual stocks is measured by the standard deviation of their returns. The average annual standard deviation for an individual stock was found to be 49.24 percent—a significant amount. According to the findings, if 10 randomly selected stocks are combined into a portfolio, its volatility dropped by more than 50 percent to an average of 23.93 percent. The volatility of a 10-stock portfolio was not significantly more than the volatility of a 1000 stock portfolio.
Based on these results, we see that diversification is easy to obtain in a portfolio. It does not require hundreds of stocks to diversify a portfolio adequately—most studies suggest that 20 to 25 stocks are sufficient. It does, however, require that stocks within a portfolio be selected from different industries to reduce the correlation among the assets. Diversification occurs in a portfolio only if the stocks selected have different types of unsystematic risk; that is, the prices of the stock do not move in lockstep because they are all in the same or highly related industries.
Diversification, while limiting your risk by spreading your investments over a larger number of securities, also limits the gains you would have received if you had concentrated your investments in a few stocks that turned out to be incredible winners. However, could you stomach investing the bulk of your fortune in a risky stock that may either climb to the moon or go bankrupt? What are the odds that you will identify very early in the life of a company the stock that in 2004 will perform similarly to Microsoft, Dell, or Cisco in the 1990s? Probably not great!
Diversifying your portfolio may not make you the next Bill Gates or Warren Buffet (both of whom became rich by focusing their investments), but if you're risk averse and feel more pain from losing than pleasure from winning, diversification is the way to go.
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