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Diversification in Portfolios of Individual Stocks: 100 Stocks Are Not Enough

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  • Dale L. Domian
  • David A. Louton
  • Marie D. Racine

Abstract

We examine returns and ending wealth in portfolios selected from 1,000 large U.S. stocks over a 20‐year holding period. Shortfall risk, the possibility of ending wealth being below a target, is a useful metric for long horizon investors and is consistent with the Safety First criterion. Density functions obtained from simulations illustrate that shortfall risk reduction continues as portfolio size is increased, even above 100 stocks. A slightly lower risk can be achieved in small portfolios by diversifying across industries, but a greater reduction is obtained by simply increasing the number of stocks.

Suggested Citation

  • Dale L. Domian & David A. Louton & Marie D. Racine, 2007. "Diversification in Portfolios of Individual Stocks: 100 Stocks Are Not Enough," The Financial Review, Eastern Finance Association, vol. 42(4), pages 557-570, November.
    • Handle: RePEc:bla:finrev:v:42:y:2007:i:4:p:557-570
    DOI: 10.1111/j.1540-6288.2007.00183.x
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    Cited by:

    1. Vitali Alexeev & Mardi Dungey, 2015. "Equity portfolio diversification with high frequency data," Quantitative Finance, Taylor & Francis Journals, vol. 15(7), pages 1205-1215, July.
    2. Li, Zhongfei & Yao, Jing & Li, Duan, 2010. "Behavior patterns of investment strategies under Roy's safety-first principle," The Quarterly Review of Economics and Finance, Elsevier, vol. 50(2), pages 167-179, May.
    3. Leković Milјan, 2020. "Cognitive Biases as an Integral Part of Behavioral Finance," Economic Themes, Sciendo, vol. 58(1), pages 75-96, March.
    4. Hannah Cheng Juan Zhan & William Rea & Alethea Rea, 2014. "An Application of Correlation Clustering to Portfolio Diversification," Working Papers in Economics 14/11, University of Canterbury, Department of Economics and Finance.
    5. Vitali Alexeev & Francis Tapon, 2014. "The number of stocks in your portfolio should be larger than you think: diversification evidence from five developed markets," Published Paper Series 2014-4, Finance Discipline Group, UTS Business School, University of Technology, Sydney.
    6. Hyung, Namwon & de Vries, Casper G., 2012. "Simulating and calibrating diversification against black swans," Journal of Economic Dynamics and Control, Elsevier, vol. 36(8), pages 1162-1175.
    7. Hannah Cheng Juan Zhan & William Rea & Alethea Rea, 2015. "A Comparision of Three Network Portfolio Selection Methods -- Evidence from the Dow Jones," Papers 1512.01905, arXiv.org.
    8. Alexeev, Vitali & Tapon, Francis, 2013. "Equity Portfolio Diversification: How Many Stocks are Enough? Evidence from Five Developed Markets," Working Papers 2013-16, University of Tasmania, Tasmanian School of Business and Economics, revised 20 Nov 2013.
    9. Sirapat Polwitoon & Oranee Tawatnuntachai, 2013. "In Search of Optimal Number of Bond Funds," Journal of Applied Finance & Banking, SCIENPRESS Ltd, vol. 3(1), pages 1-5.
    10. Haizhen Wang & Ratthachat Chatpatanasiri & Pairote Sattayatham, 2017. "Stock Trading Using PE ratio: A Dynamic Bayesian Network Modeling on Behavioral Finance and Fundamental Investment," Papers 1706.02985, arXiv.org.
    11. Jin-Li Hu & Tzu-Pu Chang & Ray Chou, 2014. "Market conditions and the effect of diversification on mutual fund performance: should funds be more concentrative under crisis?," Journal of Productivity Analysis, Springer, vol. 41(1), pages 141-151, February.
    12. Namwon Hyung & Casper G. de Vries, 2010. "The Downside Risk of Heavy Tails induces Low Diversification," Tinbergen Institute Discussion Papers 10-082/2, Tinbergen Institute.
    13. Tienyu Hwang & Simon Gao & Heather Owen, 2012. "A two‐pass model study of the CAPM: evidence from the UK stock market," Studies in Economics and Finance, Emerald Group Publishing Limited, vol. 29(2), pages 89-104, June.
    14. Libin Yang & William Rea & Alethea Rea, 2015. "Stock Selection with Principal Component Analysis," Working Papers in Economics 15/03, University of Canterbury, Department of Economics and Finance.
    15. Cheng Juan Zhan & William Rea & Alethea Rea, 2016. "Stock Selection as a Problem in Phylogenetics—Evidence from the ASX," IJFS, MDPI, vol. 4(4), pages 1-19, September.
    16. Danilo Delpini & Stefano Battiston & Guido Caldarelli & Massimo Riccaboni, 2019. "Systemic risk from investment similarities," PLOS ONE, Public Library of Science, vol. 14(5), pages 1-15, May.
    17. Florin Aliu & Besnik Krasniqi & Adriana Knapkova & Fisnik Aliu, 2019. "Interdependence and Risk Comparison of Slovak, Hungarian and Polish Stock Markets: Policy and Managerial Implications," Acta Oeconomica, Akadémiai Kiadó, Hungary, vol. 69(2), pages 273-287, June.
    18. Peter Sinka & Peter J. Zeitsch, 2022. "Hedge Effectiveness of the Credit Default Swap Indices: a Spectral Decomposition and Network Topology Analysis," Computational Economics, Springer;Society for Computational Economics, vol. 60(4), pages 1375-1412, December.
    19. Azra Zaimovic & Adna Omanovic & Almira Arnaut-Berilo, 2021. "How Many Stocks Are Sufficient for Equity Portfolio Diversification? A Review of the Literature," JRFM, MDPI, vol. 14(11), pages 1-30, November.
    20. Haensly, Paul J., 2020. "Risk decomposition, estimation error, and naïve diversification," The North American Journal of Economics and Finance, Elsevier, vol. 52(C).
    21. D'Hondt, Catherine & Elhichou Elmaya, Younes & Petitjean, Mikael, 2020. "Retail Investing in Passive Exchange Traded Funds," LIDAM Discussion Papers LFIN 2020013, Université catholique de Louvain, Louvain Finance (LFIN).
    22. David Bradfield & Brian Munro, 2017. "The number of stocks required for effective portfolio diversification: the South African case," South African Journal of Accounting Research, Taylor & Francis Journals, vol. 31(1), pages 44-59, January.
    23. Sven Husmann & Antoniya Shivarova & Rick Steinert, 2020. "Company classification using machine learning," Papers 2004.01496, arXiv.org, revised May 2020.
    24. Yunker, James A. & Melkumian, Alla A., 2010. "The effect of capital wealth on optimal diversification: Evidence from the Survey of Consumer Finances," The Quarterly Review of Economics and Finance, Elsevier, vol. 50(1), pages 90-98, February.
    25. ALIU Florin & NUHIU Artor & KNAPKOVA Adriana & LUBISHTANI Ermal & TRAN Khang, 2021. "Do Cryptocurrencies Offer Diversification Benefits For Equity Portfolios?," Studies in Business and Economics, Lucian Blaga University of Sibiu, Faculty of Economic Sciences, vol. 16(2), pages 5-18, August.

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