Market Sense and Nonsense: How the Markets Really Work (and How They Don't)

Chapter 17

Diversification: Why 10 Is Not Enough

The Benefits of Diversification

As long as investments are not highly correlated, increasing the number of holdings will reduce portfolio volatility and the magnitude of equity drawdowns, since low to moderately correlated assets will not necessarily witness losses at the same time. For highly correlated assets (e.g., mutual funds), however, more diversification will drive the portfolio toward index-like returns with minimal reduction in portfolio volatility.

Although the straightforward benefit of diversification is reduced risk, this benefit can be partially, or even totally, transformed into higher return. For example, assume that additional diversification leaves the expected return unchanged, but reduces risk levels by about 50 percent. There are three ways the portfolio manager can utilize this risk reduction:

1. Do nothing, which will result in a portfolio with approximately unchanged expected return, but half the risk of the starting portfolio.

2. Leverage the new portfolio 100 percent, which will double the expected return level and leave risk approximately unchanged.

3. Leverage between 0 percent and 100 percent, which will divide the diversification benefit between return and risk, with the relative proportions of each dependent on the degree of leverage.

Diversification: How Much Is Enough?

There is a perception fostered by academic literature that the benefits of diversification are mostly realized in the first 10 ...