Optimal Diversification

Optimal Diversification

Diversification is one of the most important and reliable methods of enhancing risk-adjusted investment performance. Diversification occurs when assets with imperfectly correlated returns are combined into a portfolio. Diversification reduces risk and can do so without reducing expected returns. Three critical questions arise in trying to diversify optimally or ideally: how many assets should be include in the portfolio, which assets should be included in the portfolio and how should the assets be weighted? Answers to these questions are based on investing in U.S. stock markets, but the principles apply to most other equity markets.
First, in the case of stock portfolios, many books and blogs suggest perhaps 20 or more individual stocks are adequate. However, there are substantial diversification benefits to including hundreds or even thousands of stocks. Given the widespread availability and very low costs of many mutual funds and exchange traded funds, investors can achieve incredibly effective diversification with a single fund purchase.
Second, which assets should be included in the portfolio? The answer is every asset that is large enough to justify the transactions costs of adding the asset to the portfolio. 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. Once again, there are many great very low cost mutual funds that can provide these broad exposures efficiently and effectively.
Finally, the relative weights of each asset in the portfolio must be selected. 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 mutual fund. This means that the fund’s largest holdings will be ten or perhaps hundreds of times larger than the fund’s smallest holdings. This idea of weighting each stock according to its size 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.
While this discussion refers to these total market portfolios as being “optimally” or “ideally” diversified, many experts believe that tweaking the Assetweights of the portfolio 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.

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