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Stock investing: Studies show need to diversify

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(MoneyWatch) The fact that so many investors fail to diversify properly is distressing given that changes in the stock markets have made diversification more important than ever. Indeed, the meaning of diversification has changed significantly in recent decades.

In December 1968, for instance, an important study concluded that investors need to construct a portfolio containing as few as 15 randomly selected stocks before the benefits of diversification (as measured by standard deviation) were basically exhausted. Related research from the same era found that 90 percent of the diversification benefit came from just 16 stocks, and 95 percent of the benefit could be captured by just 30 stocks.

Almost three decades later, a 1996 study by University of Nevada at Las Vegas finance professors Gerald Newbould and Percy Poon came to a far different conclusion. They found that "investors needed to hold more than 100 small-cap or large-cap stocks to remain within 5 percent of average risk," which they defined as the average volatility of the 40,000 simulated portfolios created for the study.

Now consider an investor who wants to achieve broad global asset-class diversification. She would need to hold more than 100 small-cap and 100 large-cap stocks. And then she would probably have to add a similar number of small-value and large-value stocks, real estate stocks, foreign stocks (large-cap, small-cap, value, and growth), emerging-market stocks, etc. There's simply no way to achieve this type of diversification by building your own portfolio of individual stocks.

What is driving this heightened need for diversification? One study, "Have Individual Stocks Become More Volatile?" coauthored among others by Princeton University economists Burton Malkiel and John Campbell, argues that a dramatic increase in the volatility of individual stocks, along with a declining correlation of stocks within the S&P 500 Index, has led to a significant increase in the number of securities needed to achieve the same level of portfolio risk. They found that for the two decades prior to 1985, in order to reduce excess standard deviation (a measure of diversifiable portfolio risk) to 10 percent, a portfolio would have had to consist of at least 20 stocks. From 1986 to 1997, that figure increased to 50.

Whereas the study found that there was a large increase in the volatility of individual stocks, the authors found no increase in overall market volatility or even industry volatility. The implication of the combination of increased volatility of individual stocks and unchanged volatility of the S&P 500 is that correlations between stocks have declined. Reduced correlation between stocks implies that the benefits of, and the need for, portfolio diversification have increased over time.

Perhaps the following is the most dramatic example of why a successful investment strategy requires broad diversification. While the 1990s witnessed one of the greatest bull markets of all time, 22 percent of the 2,397 U.S. stocks in existence throughout the decade had negative returns. Not negative real returns, but negative absolute returns. Even this shocking figure is inaccurately low. The reason is that it includes only stocks that were in existence throughout the decade (thus, there is survivorship bias in the data).

Stocks are much riskier than investors believe. That's because stock returns aren't normally distributed. The dispersion of individual stock returns doesn't resemble a bell curve where the median return is the same as the mean return. If the dispersion of individual stock returns resembled a bell curve, then the returns of half the stocks would be above the mean and half would fall below the mean.

Unfortunately for investors in individual stocks, this isn't the case. The reason is that while your profits are unlimited, you can only lose 100 percent. Thus, a few big winners (e.g., Google) cause the average return to be above the median return. As a result, there are more stocks that have below "average" returns than there are stocks with above "average" returns. This makes the purchase of individual stocks a loser's game.

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