Perhaps the largest trade-off for equity portfolio managers is between specialization and risk reduction. The fewer stocks they research and include of their portfolios, the higher they understand the underlying firms and the greater their probabilities of generating excess returns by specializing in their high-conviction positions. On the opposite hand, the less stocks they hold, the greater the portfolio’s volatility is more likely to be and the greater the likelihood of outsized losses.
So what’s the best balance? When equities are added to a portfolio, does volatility decrease equally across all equity portfolio types? Or does it vary by style? When is maximum diversification achieved?
To discover, we compared the diversification advantages of eight different portfolio styles: small cap vs. large cap, value vs. growth, dividend vs. non-dividend, and U.S. domestic vs. foreign.
We constructed our portfolios from the highest and bottom performance quartiles of NASDAQ and NYSE stocks corresponding to our various style aspects. We created a random portfolio from a certain variety of equally weighted stocks in each style and calculated its volatility using monthly returns over the 15 years from 2005 to 2020.
Then, after choosing one other random portfolio of the identical size, we performed the identical procedure 100 times and calculated the common volatility over all these iterations.
For each style cohort, we determined a mean volatility for every portfolio based on the variety of stocks it comprises.
What was the difference between large-cap and small-cap portfolios? The average volatility of a large-cap portfolio of 10 stocks was 20%. A more diverse large-cap portfolio of 40 stocks only reduced volatility to 17%. So adding 30 stocks only reduced volatility by 3 percentage points.
Maximum diversification: small-cap vs. large-cap portfolios
Adding stocks to small-cap portfolios, however, provided much greater advantages. The average small-cap portfolio of 10 stocks had a mean volatility of just over 32%, in comparison with 25% for the common small-cap portfolio of 40 stocks. So 30 additional stocks provided the small-cap portfolio with greater than twice the diversification profit as its large-cap counterpart.
The same picture emerged for dividend and non-dividend portfolios. When the common non-dividend portfolio increased from 10 to 40 stocks, volatility decreased on average by 5 percentage points, from 26% to 21%. After diversifying the dividend portfolio from 10 to 40 stocks, volatility decreased from 19% to 16%.
Maximum diversification: dividend vs. non-dividend portfolios
However, a special relationship was observed for the “Growth” and “Value” stock groups: There were no major differences in volatility because the variety of stocks increased, and the chance reduction was consistent for each groups.
Maximum diversification: value vs. growth portfolios
Finally, for portfolios consisting of U.S. and international stocks listed on NASDAQ and NYSE, volatility was barely lower when more stocks were added to the U.S. portfolio in comparison with increasing the variety of stocks within the international portfolio.
Maximum diversification: US domestic portfolio vs. international portfolio
Overall, these results show that effective diversification relies on portfolio style. For large-cap portfolios, diversification beyond about 15 stocks is of little use. For small-cap portfolios, maximum diversification is achieved with about 26 stocks. The same applies to non-dividend portfolios, while growth and value portfolios require a roughly equal variety of stocks to optimally reduce volatility.
So what’s the important thing takeaway? When it involves maximizing equity portfolio diversification, there is no one-size-fits-all solution. And equity managers should keep that in mind as they weigh the professionals and cons of specialization and risk reduction.
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