Wednesday’s Word: Diversification

By Geoff Hafer, Spring 2016 Student Intern

What is Diversification?

Perhaps the simplest explanation can be provided by the old proverb “Don’t put all your eggs in one basket.” Diversification seeks to reduce exposure to risk by combining a variety of investments, such as stocks, bonds, and real estate. It is possible to diversify both within and among different asset classes depending on investor needs. For more information see FINRA’s Diversifying Your Portfolio.

Why Diversify?

Put simply, diversify to keep those precious eggs safe. By placing each egg in a different basket, an investor is reducing exposure to risk. Variety allows an investor to manage nonsystematic risk by the fact that not all asset classes move up and down in value at the same rate or at the same time. Diversification reduces both the upside and downside potential resulting in more consistent performance under a wide range of economic conditions. Although there is a greater risk of losing perhaps one egg, there is obviously much less chance of losing them all.

How Much Diversification?

Unfortunately there is no simple answer or magic number of stocks for everyone. Studies on the subject have come to vastly different conclusions. In a paper written in 1968 by J. Evans and S.H Archer entitled, “Diversification and the Reduction of Dispersion: An Empirical Analysis,” the authors concluded that an investor needed to construct a portfolio containing “as little as 15 randomly selected stocks before the benefits of diversification were basically exhausted.” In a more recent study in November of 2014, Vitali Alexeev and Francis Tapon in a paper titled, “Equity Portfolio Diversification: How Many Stocks are Enough? Evidence from Five Developed Markets,” the authors found, “even to be confident of reducing 90 percent of diversifiable risk 90 percent of the time, the number of stocks needed on average is about 55. However, in times of distress it can increase to more than 110 stocks.” Ultimately, the decision as to how many eggs and to which basket, be it as little as 15 or more than 110, “will depend on how closely your asset classes, and investments within each asset class, track one another’s returns.”