Portfolio Diversification for Risk Reduction

Stanford University researchers looked at if and how the number of stocks in a portfolio reduces risk. Their research showed having a two-stock portfolio significantly reduced risk.

Reduction of risk continued until the portfolio had ~ 20 stocks from various industry groups. Standard deviation dropped little after this point; the difference in risk between a 20-, 50-, or 100-stock portfolio was insignificant. Standard deviation is normally calculated using 36 monthly observations (data); however, any period of time can be used. Mutual funds and advisory services update these figures quarterly.

What is most surprising about the Stanford University study is the return potential for a one- or two-stock portfolio was almost identical to the 20-, 50-, or 200-stock portfolio. This is contrary to what most of your clients believe (and perhaps most of your peers). Intuitively, people believe the “greater the risk, the greater reward.” However, this is certainly not always true.

There are times when additional risk has no benefit (e.g., from 1971, when President Nixon legalized private ownership of gold, to 2006, gold funds underperformed 5-year T-notes—yet gold mining stocks can have more volatility than aggressive growth stocks). Over the past three years (2014-2016), gold annually averaged -1.8% a year (8.2% for 2016). Over the same three years, silver annually averaged -6.9% a year (14.6% for 2016). For the past 10 years (2007-2016), gold averaged 5.8% (1.6% for silver), while U.S. investment-grade corporate bonds annually averaged 5.9%.