Reducing your stock portfolio’s volatility is getting increasingly difficult.
That’s the conclusion of researchers who—at the top of the internet-stock bubble around 22 years ago—calculated that a stock portfolio needed to own at least 50 stocks to ensure that its volatility was no greater than that of the market as a whole.
That was a much greater number than in previous decades, when as few as 15 stocks would have done the trick. But a 50-stock portfolio would still have had about the same level of volatility, since the overall market’s volatility hadn’t changed much from earlier decades at the turn of the century.
Today the picture is different, the researchers’ latest study shows. Overall market volatility has grown—markedly—over the past couple of decades. So, while 50 stocks are still enough to match a portfolio’s volatility to the overall market’s, investors would end up with a much higher level of volatility than they could have achieved with portfolio diversification before 2000.
The investment implication, says Martin Lettau, a professor at the University of California, Berkeley, and a co-author of the latest study: Since you can’t diversify away today’s greater marketwide volatility, it is something “you just have to live with.” We got a taste of that greater volatility this past week, with the Dow Jones Industrial Average gaining 932 points on Wednesday and then losing even more—1,063 points—on Thursday. If such volatility is too much for some investors to stomach, they will need to reduce their exposure to equities and invest more in asset classes such as bonds.
The study’s other co-authors are John Campbell of Harvard University, Burton Malkiel of Princeton University and Yexiao Xu of the University of Texas at Dallas.
A good illustration of the reduced potential of diversification comes from contrasting stocks’ behavior during the three bear markets this century. During the bursting of the internet bubble, a big portion of the market’s overall volatility came from stock-specific factors rather than the market as a whole. For example, while internet stocks were plunging, many other stocks were faring well. The average value stock actually made money during the 2000-02 bear market.
The net result was that the overall market was no more volatile than in prior decades. It just took a much larger number of stocks to create a portfolio with volatility that low.
In contrast, during the 2008 financial crisis and the market’s plunge in the initial weeks of the Covid-19 pandemic, share-price declines were nearly universal. Overall market factors represented a bigger share of stocks’ total volatility. As a result, even though a fully diversified portfolio still reduced volatility down to the level of the market, the net result was still more volatility than in prior decades.
Still worth trying
Given this new research’s findings, is it less important than in the internet era to own many different individual stocks? No, according to Prof. Lettau. Though the overall market’s volatility has risen, “the level of stock-specific volatility, that which can be diversified by holding many stocks, has remained high—making diversification as important as ever,” the professor says.
You could even argue that diversification has become more important than before. Since the overall stock market has become more volatile than in previous decades of U.S. history, any additional volatility would be particularly hard to stomach. “Underdiversified portfolios are not only exposed to high market volatility but also to avoidable stock-specific volatility,” Prof. Lettau adds.
So, how many different stocks should an investor own? That depends on how much volatility an investor is willing to stomach, Prof. Lettau says. But in general, 50 stocks remains a good goal, he says. If investors don’t want to own that many individual stocks, they should invest instead in a mutual fund or exchange-traded fund that contains at least that many.
This story has been published from a wire agency feed without modifications to the text