On Diversification

Abstract

Undiversified - or stock picking - portfolios may dominate well diversified benchmarks, when these benchmarks are not mean-variance efficient. Starting from Markowitz's Modern Portfolio Theory we derive simple (linear regression) tests to separate stock picking from diversification. Over 60% of the time we cannot reject our null hypothesis of stock picking in favor of well diversified benchmarks, even for individual stocks. Stock picking dominates during recessions, diversification during expansions. 'Stockpicking' stocks tend to be stocks of large size companies, stocks with high B/M, high E/P or Momentum stocks. Our new tests also explicitly relate diversification and return predictability.

Keywords: Diversification, Stock Picking, Modern Portfolio Theory, Return Predictability

JEL Classification: G11, G12, G14