Equity Portfolios: Diversification

We have seen that diversification can reduce equity risk by nullifying the company-specific risk inherent in any single shareholding. However, what can never be nullified is the risk inherent in holding stocks as an asset class. In other words, there are risk factors which affect the entire stock market, and these market or systemic risk factors - as they are known - cannot be diversified away.

Research shows that most well developed stock markets, company-specific risk accounts for about two-thirds of a share’s total risk. The exact level of specific to market risk depends on the size and diversity of the particular stock market; but for mature markets such as the US and UK, portfolio diversification can negate around 65 to 70% of total equity investment risk.

This then begs the questions, how much stock diversification is necessary to nullify specific risk? Again research can help provide an answer.

Here is the risk of holding one stock - 100%; and the risk of holding all stocks - around 30%.

The investment risk of holding any one stock is going to be 100%. You are totally exposed to company-specific and market risk. Now if you hold all the stocks in the market, clearly you will diversify away all company-specific risk. So your investment risk will consist purely of the market risk which cannot be diversified away. This, for mature markets, is around 30%. So,with a well-diversified portfolio, investors' will bear only the inescapable market risk and capture equity market returns.

In fact, as long as stock holdings are spread between industry sectors so that the portfolio is reasonably representative of the market in terms of industry sectors and capitalisation, then diversifying into about 30 shares typically captures around 90% of the benefits of diversification.

This means that a portfolio holding a broad range of 25+ shares will roughly capture the market’s average returns in return for taking on market risk. To precisely capture a stock market’s returns without holding each and every share in the market is a more difficult business. It is called index-tracking, an exercise in creating a portfolio which will exactly mirror market risk and return.

But most investors tend to want to outperform the average. This will mean avoiding total diversification –taking on some specific risks in pursuit of outstanding returns.