How Many Alternative Eggs Should You Put in Your Investment Basket?

Abstract

There is some debate about how many stocks can effectively eliminate most of the unsystematic risk in an equity portfolio. Estimates range from 10 to 40. Given the growing proliferation of pooled investment vehicles aimed at the UK's pension fund industry, where these pools consist of various combinations of alternative asset classes and alternative investment strategies, in this paper we investigate the limits of diversification amongst these less conventional investments. Our results indicate that 40% of the time series risk can be eliminated by combining 8 strategies, but only a further 4% from combining 12. We also find that an investor could reduce 60% of the dispersion in terminal wealth of an alternative investment basket - which is arguably what investors should really be concerned with - by combining 6 of these less conventional asset approaches to investment, but only a further 20% by combining 15.

Keywords: Alternative asset classes, portfolio diversification, diversifiable risk

JEL Classification: G0