GETTING THE MOST OUT OF DIVERSIFICATION
Diversification is one of the most important and reliable methods of enhancing risk-adjusted investment performance. But can we diversify in a way that gives our portfolios the best reductions in risk? In this article I discuss which securities to select and how to weight them.
Diversification occurs when assets with imperfectly correlated returns are combined into a portfolio. Diversification reduces risk and can do so without reducing expected returns. Two critical questions arise in trying to diversify optimally or ideally: which assets should be included in the portfolio and how should the assets be weighted? My answers to these questions are provided in the context of investing in the U.S. stock market, but the principles apply quite generally.
First, which stocks should be selected for a diversified portfolio? Many books and blogs suggest perhaps 20 or more individual stocks are adequate. Often it is suggested that the stocks be selected to represent a variety of industries or sectors. However, there are substantial diversification benefits to including hundreds or even thousands of stocks. Accordingly, my answer is to select all the available stocks. Given the widespread availability and very low costs of many mutual funds and exchange traded funds that index to the total US equity market, investors can achieve incredibly effective diversification with a single fund purchase.
While some funds might focus on stocks of a particular size (e.g., large cap), others often focus on types of stocks such as growth stocks, value stocks, income stocks, or stocks within a particular sector. But in the case of well-developed markets such as the U.S. equity market, the highest level of diversification occurs by including all stocks.
The other issue is how to select the relative portfolio weights of each asset in the portfolio. Modern portfolio theory teaches that the best diversification occurs when each asset is weighted in direct proportion to its size. Thus if the aggregate value of a huge firm such as Apple represents 3% of the overall equity market, then it should represent 3% of the aggregate value of the ideally-diversified portfolio. This means that the portfolio’s largest holdings will be hundreds or even thousands of times larger than the fund’s smallest holding.
The idea of weighting each stock according to its size (“market weighting”) seems to run counter to the idea of being well-diversified since so much of the fund’s performance will be dominated by the stocks of the biggest firms. But in a competitive market, prices adjust such that market-weighted portfolios provide, in theory, the best diversification. The funds that strive to hold or mimic these portfolios are often termed total market index funds. Many of these funds are available with no loads and with ultra-low expense ratios.
Many experts believe that tweaking the weights of the portfolio away from market weights can provide better risk-adjusted returns or perhaps other advantages such as more appropriate tax exposures. Undoubtedly there are experts able to construct portfolio with superior risk-adjusted returns and there are considerations such as investment income taxes that may make total market portfolios less than ideal. However, total market index funds provide an excellent reference point for investing. Investors are well advised to use ultra-low-cost total market index funds unless they have expertise in investing or have trusted advisors who are experts in investing.