The True Benefit of Diversification

Harry Markowitz, the Nobel laureate founder of Modern Portfolio Theory, called diversification “the only free lunch in finance.” Increased diversification provides reduced volatility with no loss in expected return. However, it is a mistake to believe that this is the only benefit of diversification, as demonstrated in a recent research article from Dimensional, “How Diversification Impacts Investment Outcomes: A Case Study on Global Large Caps” by Wei Dai and Matt Wicker.

The authors ran returns for simulated global large cap portfolios with varying levels of diversification. As expected, annualized volatility varied inversely with diversification level. However, a portfolio of only 50 companies had only about a 0.5% higher annualized volatility (standard deviation) than the whole universe of 2,637 companies, suggesting that high levels of diversification are a waste of resources. To see why this is not the case, we must dig a little deeper.

If a portfolio is constructed with the purpose of capturing the return of a market or a particular segment of the market that is expected to outperform, then it is desirable to minimize the amount of tracking error between the portfolio and its benchmark. The authors found that a portfolio of 50 stocks had almost double the tracking error of 200 stocks and almost triple of 500 stocks. The authors conclusively showed that the higher tracking errors of more concentrated portfolios lead to an increase in the probability of underperformance. For example, over a five-year period, the 50-stock portfolio had a 37% probability of underperforming the global benchmark (MSCI All-Country World Index) while a 500-stock portfolio had only 16%. It is important to note that both portfolios were tilted towards small cap, value, and profitability, all of which increase the expected return over the global market.

To conclude, when choosing a fund for the purpose of investing to meet long-term goals, the number of holdings is very important not only to avoid unnecessary volatility but to maximize the probability of attaining the targeted returns.