How Many Stocks Are Sufficient for Equity Portfolio Diversification? A Review of the Literature

Azra Zaimović · Adna Omanovic · Almira Arnaut-Berilo

78 citations0/0 files storedJournal of risk and financial management

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Financial Markets and Investment Strategies Financial Risk and Volatility Modeling Risk and Portfolio Optimization

Abstract

Using extensive and comprehensive databases to select a subset of research papers, we aim to critically analyze previous empirical studies to identify certain patterns in determining the optimal number of stocks in well-diversified portfolios in different markets, and to compare how the optimal number of stocks has changed over different periods and how it has been affected by market turmoil such as the Global Financial Crisis (GFC) and the current COVID-19 pandemic. The main methods used are bibliometric analysis and systematic literature review. Evaluating the number of assets which lead to optimal diversification is not an easy task as it is impacted by a huge number of different factors: the way systematic risk is measured, the investment universe (size, asset classes and features of the asset classes), the investor’s characteristics, the change over time of the asset features, the model adopted to measure diversification (i.e., equally weighted versus optimal allocation), the frequency of the data that is being used, together with the time horizon, conditions in the market that the study refers to, etc. Our paper provides additional support for the fact that (1) a generalized optimal number of stocks that constitute a well-diversified portfolio does not exist for whichever market, period or investor. Recent studies further suggest that (2) the size of a well-diversified portfolio is larger today than in the past, (3) this number is lower in emerging markets compared to developed financial markets, (4) the higher the stock correlations with the market, the lower the number of stocks required for a well-diversified portfolio for individual investors, and (5) machine learning methods could potentially improve the investment decision process. Our results could be helpful to private and institutional investors in constructing and managing their portfolios and provide a framework for future research.

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References

1952PORTFOLIO SELECTION*2001Have Individual Stocks Become More Volatile? An Empirical Exploration of Idiosyncratic Risk 2002International Asset Allocation With Regime Shifts 1997Why is there a home bias? An analysis of foreign portfolio equity ownership in Japan 1974Why Not Diversify Internationally Rather Than Domestically?2007Equilibrium Underdiversification and the Preference for Skewness 1987How Many Stocks Make a Diversified Portfolio?1968DIVERSIFICATION AND THE REDUCTION OF DISPERSION: AN EMPIRICAL ANALYSIS*

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