Main Ideas Based on a Journal of Finance article published in 2001 Free lunch: reduction in risk through diversification Many investors ignore this free.

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Presentation transcript:

Main Ideas Based on a Journal of Finance article published in 2001 Free lunch: reduction in risk through diversification Many investors ignore this free meal. Well known examples: Local bias Over-investment in company stocks Home bias 2

Rule of Thumb 20 randomly-selected stocks can provide adequate diversification This article: True 40 years ago Today, stocks have become more volatile, and require 50 randomly-selected stocks Figure 1: Excess volatility of portfolios Compare to standard deviation of a well-diversified index of all U.S. stocks “Adequate” diversification:  does not go much lower as you increase # of stocks 3

Observations 1963 – 1985 volatility fairly stable 1986 on: Curve sits much higher (individual stocks more volatile) But slope is steeper (volatility is reduced more quickly, or effectively, because of lower correlation among stocks) Change in rule of thumb from 20 to 50 randomly- selected stocks 4

p.205 in text Similar diagram, but volatility is not benchmarked Look at absolute, rather than relative, volatility 5

International Diversification Benchmark: MSCI World index (the fully- diversified portfolio) Look at excess volatility over and above (the standard deviation of) this index Figure 2 Average excess volatility if invest in one country Average excess volatility if invest in one sector (e.g., portfolio of telecommunication companies in the world) 6