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INVESTMENT QUIZ ANSWER

15 /50/100/200/350

Diversification (2000): This will screw up all stock portfolios. (Burton Malkiel, Bloomberg) Individual stock volatility has increased. From 1965 to 1985, it took a portfolio of about 20 stocks to reduce excess standard deviation to 10%. (You actually have to see the chart as identified in Investments by Bodie, Kane and Marcus and the more recent in Bloomberg's wealth Manager. The chart shows the level of diversifiable risk closing rapidly between 10 and 15 stocks with a slightly greater reducing at 20. Hence you might understand my use of 13 stocks as reflecting proper diversification. However that is also assuming that the stocks were not all in the same arena.) But a new study from 1986 to 1997 indicates that in order to achieve a comparable level of risk one would now need 50 stocks instead of the 20.  

You need to recognize that it is NOT the MARKET'S volatility that has actually increased- actually it has stayed relatively flat for decades. It's just the the absolute change in daily movement- say 200 points- seems so much bigger than in the past. However with the DOW/S&P index is so high, the relative movement is not that much different than in the past.

So what is going on?? "Declining correlations allow the volatility of the market portfolio to remain the same even if there is an increase in the individuals stocks volatility". In essence, as I look at the chart, in order to get the same diversification as you used to get with the  13 stocks I recommended, you now need at least 40.

There are variations to this. And here is a further article on Diversification: William Bernstein suggests you need up to 200+ stocks. If you say you really are an investor- you've got to read this

"if you think that you can do an adequate job of minimizing portfolio risk with 15 or 30 stocks, then you are imperiling your financial future and the future of those who depend on you. The reason is simple: There are critically important dimensions of portfolio risk beyond standard deviation. The most important is so-called Terminal Wealth Dispersion (TWD). In other words, it is quite possible (in fact, as we shall soon see, quite easy) to put together a 15-stock or 30-stock portfolio with a very low Standard Deviation, but whose lousy returns will put you in the poorhouse."

I do recognize that the most recent studies are known by few. However you should have understood at least the number 15 as well as the adjustment to at least 50. If so, you  are probably well grounded in the fundamentals of investing. You might be able to buy stocks and understand the risk. If you did not get the right answer, call your broker/agent/planner and ask them for the answer and the verification. If they cannot provide the answer, they are probably not grounded in the fundamentals of investing (remember, this is NOT taught in licensing training). If you continue to buy stocks and most other investments from this individual, now you are both stupid. In any case, you certainly have no business buying individual securities.

If you do not understand the fundamentals of diversification, any good returns were probably based on luck or extra risk- particularly in view of the recent studies. Neither is good for long term investing. .

Update 2/2001: As identified in the 2001 Investor's Guide, a study led by professors John Campbell of Harvard and Burton Malkiel of Princeton shows that, "The number of stocks needed to obtain any given amount of portfolio diversification has increased" in recent decades. It determined that the volatility of individual stocks has more than doubled since 1962, although the stock market as a whole is not much more volatile because the stocks often offset each other. A portfolio once required 12 stocks (I used 13 in my teachings) to properly diversify and track the S&P 500, but the reducing correlations pushed that to 50. A WSJ article noted that a University of Nevada article says that investors need up to 100 stocks to stay within 5% of average portfolio risk. Research by CooperNeff show investors need 350.

Regardless of which number you accept- 50 or 350- it is literally impossible for a human being to decipher all of a company's financial data and incorporate it with national and worldwide economics and determine if the selection is valid. And then to do it for another 40+ stocks that incorporate various sections such technology, health, transportation, etc. is statistically impossible. Yes, you might be successful for a time but it was probably due more to luck and current market momentum than it was to skill.

And more- DIVERSIFICATION: (WSJ) Ronald Surz and Mitchell Price calculated returns for portfolios of 15 randomly selected stocks over the 13½ years through June 1999.

The authors found that among such randomly selected 15-stock baskets, the typical portfolio strayed as much as 8.1 percentage points a year from the market's return. Thus, if the market was up 11% in a given year, the typical portfolio might gain as much as 19.1% -- or as little as 2.9%.

What if you are careful to pick a group of 15 well-diversified stocks? The typical tracking error was 5.4 percentage points. Some 15-stock portfolios strayed far more than this amount, while others would track the market more closely. Even if you held 60 stocks and even if you were careful to diversify, the typical tracking error was still 3.5 percentage points a year.

At the level of 300 or 400 stocks, you're probably down to one or two percentage points of tracking error.

The only way to eliminate this tracking error is to own the entire market, preferably through a low-cost index fund that mimics the Wilshire 5000 or the Russell 3000.