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MARKETS | JOURNAL REPORTS: FUNDS/ETFS
5 Myths About Stock Diversification
No. 1: You don’t really get much benefit going beyond 12 to 18 stocks. Wrong.
There is a better way to understand diversification, writes this professor: It ensures that your money is never concentrated in
the worst-performing assets.
PHOTO: ROB DOBI
By Meir Statman
Updated Aug. 8, 2020 4:00 pm ET
Diversification is often described as the only free lunch in investing—reducing a
portfolio’s risk without reducing expected return. This idea of spreading money across
different kinds of investments is so accepted and so straightforward that it is a
fundamental principle that even the most unsophisticated investors know about it.
But while many individual investors think they understand diversification, they often fall
prey to certain myths that keep them from fully partaking in this free lunch.
First, let’s look at how diversification reduces risk.
Investors commonly assess the risk of a portfolio by the volatility of its returns, which is
usually measured by standard deviation, or how widely prices range from the average
price. The standard deviation of portfolio returns declines with each stock (or
investment) added.
There is, however, a better way to understand diversification: It ensures that your money
is never concentrated in the worst-performing assets, thus saving you from being a
bottom investor.
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To illustrate, compare a portfolio of one stock to a better-diversified portfolio, composed
of two stocks, A and B. During any given year, one stock will return 22% and the other
minus 6%, but you don’t know which stock will turn in the positive performance and
which the negative. A portfolio composed only of A or only of B would yield either 22%,
making you a top investor, or minus 6%, making you a bottom investor. But a diversified
portfolio of A and B, say in 50-50 proportions, would make you a mediocre investor, with a
return of 8%.
Diversification blocks you from being a top investor. But by eliminating the risk that you
will ever be a bottom investor, it provides a safer way to make your money grow over time.
Here, then, is a look at some diversification myths and how they can hurt investors:
Myth 1: Diversifying a portfolio beyond 12 to 18 stocks offers no benefits.
Many investors, including investment experts, note that you can obtain more than 90% of
the benefits of diversification by owning just 12 to 18 stocks.
That statement is true, but the implication that there is no benefit to extending
diversification beyond 12 to 18 stocks is a myth. More diversification always pays off—as
long as the benefits of adding an investment exceed the costs of making the addition.
To illustrate, imagine that I place 19 gold coins in front of you and say that you can take as
many as you like. Now suppose you have taken 18 of the coins, amounting to more than
94% of the 19 coins. Would you stop, or take the 19th? As you contemplate your choice you
ask yourself what is the marginal benefit of taking the 19th coin? Say it is $1,000, the
coin’s worth. What is the marginal cost of taking that coin? Virtually nothing, just a flick
of your fingers. The choice is simple. Get the 19th coin.
So while the marginal benefits of increasing diversification from 18 stocks to 19 stocks
may be small, the marginal costs of increasing diversification from 18 stocks to 19 are
essentially zero when investing in an index fund or ETF containing thousands of stocks,
way more than 19, and charging a 0.04% annual fee.
To be sure, the cost of diversification is enormous if you diversify on your own into
thousands of stocks or other investments with high expenses. Efficient diversification is
accomplished by low-cost index funds or ETFs.
Myth 2: Owning a handful of stocks you know is safer than a portfolio of
thousands of stocks you don’t know.
“Invest in what you know.” How many times have we heard that?
Too many, it seems.
A recent study from researchers at the University of Colorado found that many investors
are convinced that a smaller portfolio composed of companies they know and understand
is much less risky than a diversified portfolio of thousands of companies they don’t know.
When investors have too many stocks to research and monitor, they are likely to miss
something important and lose their competitive edge—or so the thinking goes.
In reality, most of the returns of the market over time are generated by a very small
number of stocks. A 2018 study published in the Journal of Financial Economics found
that the best-performing 4% of stocks each year collectively account for the total gain of
the stock market since 1926.
If you choose to own only a fraction of the more than 3,500 publicly traded stocks in the
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U.S., what are your odds of picking exactly the right ones? They are very small, probably
similar to picking a winning lottery ticket.
If you decide to invest in virtually all of the publicly listed stocks in the U.S. through a total
stock-market index fund, however, the odds that you will hold tomorrow’s biggest
winners are essentially 100%.
Therefore, portfolios of 12, 18 or even hundreds of stocks are likely to lag behind a
diversified index fund containing almost all stocks over time because the undiversified
portfolio is likely to miss the “super stocks” that will be driving most of the market’s
future returns.
Many investors lost faith in diversification during the financial crisis of 2008, when everything went
down.
PHOTO: ROB DOBI
Myth 3: Owning an index fund provides you with diversification.
An S&P 500 index fund is more diversified than a portfolio composed of a handful of
stocks. But an S&P 500 fund isn’t nearly as diversified as a total stock-market index fund.
That’s because the S&P 500 index comprises mostly large-capitalization companies, or
those with relatively large total value of all their shares. In any year, the return of an index
fund of large-cap stocks is likely to be different than the return of an index fund composed
of small-cap stocks. And the returns of both are likely to differ from that of a total stock-
market index fund, which includes both large- and small-cap companies.
A look at Vanguard’s index funds illustrates this point. In 2003, the return of Vanguard
500 Index Fund Admiral shares (VFIAX), a fund that seeks to track the performance of the
S&P 500, was 28.6%, while the return of Vanguard Small-Cap Index Fund Admiral
(VSMAX) was 45.8%. The return of Vanguard Total Stock Market Index fund (VTSAX) that
year was 31.4%, in between the returns of the two index funds, reflecting its greater
diversification. In other years, such as 2017, the return of the S&P 500 index fund
exceeded that of the small-cap fund, but the return of the total stock-market index fund
was in between, as always.
The same concept holds true for index funds focused on value stocks, growth stocks, high-
dividend stocks and so on. Their returns will reflect one slice of the market and could
differ substantially from that of the stock market as a whole.
Those interested in building a diverse portfolio might start with three index funds: a total
U.S. stock fund, a total international stock fund and a total bond fund. From there,
investors can fine-tune, based on their individual needs and goals.
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Myth 4: U.S. and international stocks are closely correlated, so there is no
diversification benefit in owning both.
In general, when two investments are closely correlated, the difference in their returns is
usually smaller and the diversification benefits of owning both lower. But correlation isn’t
the only factor investors should consider. The volatility of the two investments’ returns
also is important. When volatility (as measured by standard deviation) is high, the
average difference between returns can be high, which increases the diversification
benefits of owning the investments.
Looking at Vanguard index funds again, it is clear that U.S. and international stocks are
closely correlated. From 2000 to 2019, the correlation between the returns of Vanguard’s
total U.S. stock fund and its total international stock fund was 89%, not far from the 100%
perfect correlation.
But a look at their returns shows benefits of diversifying between U.S. and international
stocks were great.
For example, whereas the return of the total U.S. stock fund in 2006 was 15.6%, the return
of the total international fund that year was much higher at 26.6%. And whereas the
return of the total U.S. stock fund in 2019 was 30.8%, the return of the total international
fund that year was much lower, 21.5%. The difference in returns—11 percentage points in
2006 in favor of international stocks, and 9.3 percentage points in 2019 in favor of U.S.
stocks—points to significant diversification benefits in owning both types of stocks.
The story of the returns of U.S. corporate bonds and U.S. government bonds complement
the story. The correlation between the returns of the two kinds of bonds from 2000 to
2019 also was 89%, identical to the correlation between the returns of U.S. stocks and
international stocks, but the volatility of the returns of bonds is lower than that of stocks.
That resulted in smaller differences between the returns of two kinds of bonds than
between the two kinds of stocks, and lower benefits of diversification between bonds.
Myth 5: Market timing is necessary, in addition to diversification.
Many investors lost faith in diversification during the financial crisis of 2008, when both
U.S. and international stocks were decimated. Vanguard’s U.S. total stock-market index
fund plunged 37% in 2008, while its international stock-market index fund fell 44.1%. The
difference in performance was 7.1 percentage points, indicating substantial diversification
benefits, but these benefits elicited few cheers. In contrast, an index fund of long-term
bonds, combining U.S. corporate and government bonds, gained 8.8% that year.
That led some investment pros to suggest that in
THE READERS RESPOND addition to diversification, money managers
•Investors Still Believe They Can Beat the Stock should engage in so-called tactical methods, too.
Market (September 2020) They were referring to tactical asset allocation,
or timing the market. These pros imply that
competent money managers would have sold
stocks and bought bonds at the end of 2007,
avoiding the 2008 crash, and reverted back to stocks in time for 2009, when the U.S. total
stock-market index fund gained 28.8% and the total international stock-market index fund
gained 36.7%.
But market timing is easier said than done. Amateur investors trying to time the market
tend to buy and sell at all the wrong times and end up underperforming their buy-and-
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hold peers.
Diversification protects us from being bottom investors, as we abandon hope of being top
investors. Successful market timing can make us top investors, but it is likely to be
unsuccessful, turning us into bottom investors.
That said, the two approaches can coexist. You can own a total stock-market index fund
and then, in a different account, also make bets on a handful of stocks you believe will
earn extraordinary returns. But investing in just a dozen or so stocks and expecting
extraordinary returns is just too risky for most investors.
Dr. Statman is the Glenn Klimek professor of finance at Santa Clara University’s business
school and author of “Behavioral Finance: The Second Generation” (available free at
cfainstitute.org). He can be reached at [email protected].
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