How efficient is naive portfolio diversification? An educational note

Gordon Y N TANG*

*Corresponding author for this work

    Research output: Contribution to journalJournal articlepeer-review

    48 Citations (Scopus)

    Abstract

    Standard textbooks of Investment/Financial Management teach that although portfolio diversification can help reduce investment risk without sacrificing the expected rate of return, the benefit of diversification is exhausted with a portfolio size of 10-15. Since by then, most of the diversifiable risk is eliminated, leaving only the portion of systematic risk. How valid is this "common" knowledge? What is the exact value of "most" in the above statement? This paper examines the issue on naive (equal weight) diversification and analytically shows that for an infinite population of stocks, a portfolio size of 20 is required to eliminate 95% of the diversifiable risk on average. However, an addition of 80 stocks (i.e., a size of 100) is required to eliminate an extra 4% (i.e., 99% total) of diversifiable risk. This result depends neither on the investment horizons, sampling periods nor the markets involved.

    Original languageEnglish
    Pages (from-to)155-160
    Number of pages6
    JournalOmega
    Volume32
    Issue number2
    DOIs
    Publication statusPublished - Apr 2004

    Scopus Subject Areas

    • Strategy and Management
    • Management Science and Operations Research
    • Information Systems and Management

    User-Defined Keywords

    • Diversifiable risks
    • Efficiency
    • Naive diversification
    • Portfolio

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