How Much Diversification is Enough?
21 Pages Posted: 25 Feb 2003
Date Written: October 2002
Levels of diversification in the portfolios of investors present a puzzle. The benefits of diversification, measured by the rules of mean-variance portfolio theory, have increased in recent years, yet levels of diversification did not increase, remaining much below their optimal levels. We find that today's optimal level of diversification, measured by the rules of mean-variance portfolio theory, exceeds 120 stocks, and argue that the diversification puzzle is solved within Shefrin and Statman's (2000) behavioral portfolio theory. Investors in behavioral portfolio theory construct their portfolios as layered pyramids where bottom layers are designed for downside protection while top layers are designed for upside potential. Risk-aversion gives way to risk-seeking at the uppermost layers as they desire to avoid poverty give way to the desire for riches. Some investors fill the uppermost layers with the few stocks of an undiversified portfolio while others fill them with lottery tickets. Neither lottery buying nor undiversified portfolios are consistent with mean-variance portfolio theory but both are consistent with behavioral portfolio theory. Behavioral portfolios, such as those reflected in the rules of "core and satellite," are sensible ways to allocate portfolio assets between the upside potential and downside protection layers. A well-diversified core forms is the downside protection layer of the portfolio and a less diversified satellite forms the upside potential one. The rules of diversification in behavioral portfolio theory are not as precise as the rules in mean-variance portfolio theory, but they are clear enough. Investors, financial advisors, and companies sponsoring 401(k) plans must be careful to draw the line between upside potential and downside protection such that dreams of riches do not plunge investors into poverty.
Keywords: Diversification, portfolio choice
JEL Classification: G11
Suggested Citation: Suggested Citation