The Effect of Portfolio Construction Rules on the Relationship Between Portfolio Size and Effective Diversification

Abstract

It is acknowledged by researchers and practitioners alike that risk reduction through portfolio diversification provides significant economic benefits. Less obvious is the size of the portfolio one would need to receive 50% or 90% of the possible benefits. If ownership of 100 securities is necessary to achieve half the possible risk reduction, diversification would be of practical use only for institutions and the extremely wealthy. Numerous empirical studies have examined this question, and most conclude that effective diversification is possible with a surprisingly small number of securities if the securities are chosen at random. The force of this evidence is reduced because all but two of these studies assigned equal weights to the securities selected for a portfolio. There can be no presumption that equal weights are optimal, and the evidence cannot be conclusive unless optimal weights are used. I. Earlier StudiesIn a seminal work in this area, Evans and Archer [4] concluded that there is relatively little economic justification for increasing portfolio sizes beyond ten or so randomly selected securities. Latane and Young [9] verified Evans and Archer's results, finding that an eight-stock portfolio achieves 85 percent of the possible gains through diversification. Fisher and Lorie [5] have also confirmed that increasing the number of stocks in a portfolio rapidly exhausts the variability present in a one-stock portfolio. For example, they found that while roughly 40% of the achievable reduction is obtained by holding two stocks, eight stocks reduce 80% of the dispersion. Sharpe [14, p. 130] agreed that "a little diversification can go a long way toward reducing risk." He suggested that a portfolio containing fifteen or so securities may be considered well-diversified. Elton and Gruber [2] reached the same conclusion from an analytical solution of the relationship between risk and portfolio size. Finally, Mokkelbost [12] also found that a major portion of the achievable reduction is accomplished when "relatively few" different securities are included in the portfolio.Two recent studies have questioned whether portfolios of only 10 to 20 securities sufficiently reduce variation. Lorie [10] argued that even small departures from perfect diversification create substantial amounts of risk. Concentrating on the variance in independent returns for different size portfolios, he showed that a choice of 50 stocks out of the Standard and Poor's 500 Index could produce annual returns that vary as much as four and one-half percentage points from the returns for the entire 500 stocks. Moreover, even as large a portfolio as 100 stocks might differ as much as three percentage points from the 500 stock index. Using Fisher and Lorie's earlier data, Upson, Jessup, and Matsumoto [15] make much the same point when they argue that small portfolios suffer

A Comparison of Risk Measures When Used in a Simple Portfolio Selection Heuristic

“…Alexander and Chervany (1980) found that the performance of beta deteriorated when portfolios smaller than 10 securities were tested. The maximum size of 30 securities was chosen since with a 650 security universe, Lloyd, Hand and Modani (1981) found that optimal diversification required no more than 27 securities. The 15 and 20 security portfolios were chosen to fill in two more locations on the efficient heuristic frontier.…”

“…A market index was constructed by giving each of the 150 securities in the sample an equal weight. This is an acceptable procedure since both Lloyd, Hand and Modani (1981) and Frankfurter (1976) have found that the ex post performance of beta is not sensitive to the choice of market indexes. This study is based on a simple historical estimation and extrapolation test of the various risk measures with no adjustments made to any of the measures.…”

Risk reduction and real estate portfolio size

“…See, for example, Jones Lang Wootton (1986), Barber (1991), Cullen (1991), Myer et al (1997) and Byrne and Lee (2000) for studies in the property market, and Evans and Archer (1968), Wagner and Lau (1971), Johnson and Shannon (1974), Tole (1982) and Lloyd et al (1981) for studies in equity and bond markets.…”

The impact of portfolio size on the variability of the terminal wealth of real estate funds

“…Since the seminal work of Markowitz (1952) various studies have examined the number of stocks required to form a well-diversified equity portfolio (see for example, Evans and Archer 1968;Wagner and Lau 1971;Johnson and Shannon 1974;Elton and Gruber 1977;Tole 1982;Bird and Tippett 1986;Lloyd et al 1981 andStratman 1987). The approach mainly adopted in such work has been the simulation of a large number of equal-weighted portfolios of ever increasing size with the investigation of the reduction in average portfolio risk (standard deviation) afforded by adding stocks incrementally to the portfolio.…”