2008.May.Digest.

book Page 66 Monday, April 21, 2008 10:47 AM

66 CFA Digest May 2008

PORTFOLIO MANAGEMENT

Diversification in Portfolios of Individual Stocks:

100 Stocks Are Not Enough
Dale L. Domian, CFA, David A. Louton, and Marie D. Racine
Financial Review
vol. 42, no. 4 (November 2007):557570
Standard investment methodology suggests much of the benefit
from diversification is achieved with a portfolio of between
8 and 20 stocks. Investors with a long-term investment horizon,
however, might be concerned with shortfall risk that could result
in ending wealth levels significantly below target. Using a
20-year return series for 1,000 large common stocks and a
Safety First criterion, the authors conclude that even 100 stocks
may not be enough to alleviate significant levels of shortfall risk.
Although portfolios with a small number of stocks can further
reduce risk by diversifying across industries, even greater risk
reduction is achieved by simply increasing the number of stocks
in the portfolio.

Traditional portfolio management theory asserts that portfolios

should be well diversified. Early studies claimed that most benefits of
diversification could be obtained with portfolios having as few as 8
and no more than 20 individual stocks. These results follow from the
original research of Evans and Archer (Journal of Finance, 1968).
That study focused on comparing the variance of a single asset with
the variance of portfolios having increasingly more securities. More
recent studies suggest that investors with long time horizons should
be concerned with shortfall risk, which is the risk that ending wealth
will be less than the desired target amounts. These studies infer that
more than 20 stocks are needed for full diversification benefits.
Dale L. Domian, CFA, is at York University. David A. Louton is at Bryant University.
Marie D. Racine is at the University of Saskatchewan. The summary was prepared
by Frank T. Magiera, CFA.

2008, CFA Institute

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Portfolio Management 67

Damian, Louton, and Racine use a shortfall approach to determine

the appropriate number of stocks to hold in a portfolio. They examine
returns and ending wealth for portfolios selected from 1,000 large
U.S. common stocks based on market capitalization. The stocks are
classified into 10 industry groups, each with roughly the same number
of stocks.
They use a 20-year investment horizon for the period of 19852004
and also use a second 20-year period of 19651984 to serve as a
robustness check and compensate for any period-specific results.
During the 20-year period, companies leave the sample due to various
events, such as delisting as a result of bankruptcy or mergers. A
sampling technique is used to overcome attrition and avoid survivorship bias. For example, during the 19852004 period, 615 stocks drop
out as a result of delisting. Replacement companies with the largest
market capitalization for that industry group and not already included
in the sample are chosen. Returns from the original set of companies
and replacement companies are spliced together to form a dataset
consisting of 1,000 return series spanning the entire 20-year period.
At the end of 2004, negative returns are exhibited for 246 of the return
series, with the worst returns typically for return series having companies delisted as a result of financial distress. The highest return series
is for Microsoft Corporation with a return of 39.1 percent per year.
This high return series began with MGM Entertainment in 1985, but
continued with Microsoft, which replaced MGM on 25 March 1986.
Shortfall risk is measured relative to the return on a risk-free asset.
The authors generate probability distributions to measure the effect
on wealth and risk from varying the number of stocks in the portfolio.
They compare the results for portfolios using random diversification
with the results when portfolios are formed by diversifying across
industry groups. The former method does not guarantee that all
industries will be represented in a portfolio. The findings indicate that
industry diversification provides a modest advantage for the lowest
wealth distributions for the smallest portfolios. Industry diversification
is found to usually be disadvantageous at the higher wealth distributions. In general, the benefits of industry diversification can easily be
duplicated by simply increasing the number of stocks in the portfolio.
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68 CFA Digest May 2008

Most prior studies utilize a buy-and-hold methodology, which can

lead to less diversification over the 20-year time period. With buyand-hold strategies, the best-performing stocks become an increasingly larger proportion of the ending portfolio value and the poor
performers become lesser amounts with negligible impact on wealth.
Annual portfolio rebalancing can provide some adjustment to ending
wealth. The findings show annual rebalancing reduces risk at the
lower end of the wealth distributions, but may not be enough to offset
costs inherent in rebalancing.
The authors conclude that even 100 stocks may not be enough to
alleviate significant levels of shortfall risk. Using the Safety First
criterion, they find that 164 stocks were needed to have at most a 1
percent chance of underperforming U.S. Treasury bonds during the
19852004 period.
Keywords: Portfolio Management: asset allocation; Portfolio Management: equity
strategies; Private Wealth Management: asset allocation; Risk Measurement and
Management: equity portfolios

2008, CFA Institute