Why it's harder to reduce volatility in a stock portfolio

Why it’s harder to reduce volatility in a stock portfolio

Reducing the volatility of your stock portfolio is becoming increasingly difficult.

That’s the conclusion of researchers who, at the peak of the internet stock market bubble some 22 years ago, calculated that a stock portfolio needed to have at least 50 stocks to ensure its volatility was not higher than that of the market as a whole.

That was a much higher number than in previous decades, when just 15 stocks would have done the trick. But a portfolio of 50 stocks would still have had roughly the same level of volatility, since overall market volatility hadn’t changed much from previous decades around the turn of the century.

Today, the situation is different, according to the researchers’ latest study. Overall market volatility has increased markedly over the past two decades. So while 50 stocks is still enough to match a portfolio’s volatility to that of the overall market, investors would end up with a much higher level of volatility than they could have achieved with portfolio diversification before 2000. .

The investment implication, says Martin Lettau, a professor at the University of California, Berkeley and co-author of the latest study: Since you can’t diversify today’s greater market volatility, it’s is something “you just have to live with.” We got a taste of this greater volatility last week, with the Dow Jones Industrial Average gaining 932 points on Wednesday, then losing even more – 1,063 points – on Thursday. If such volatility is too high for some investors, they will need to reduce their equity exposure and invest more in asset classes such as bonds.

Other co-authors of the study are John Campbell of Harvard University, Burton Malkiel of Princeton University and Yexiao Xu of the University of Texas at Dallas.

The challenge of diversification

A good illustration of the reduced potential for diversification comes from the contrasting behavior of equities during the three bear markets of this century. During the bursting of the dot-com bubble, much of the overall market volatility came from stock-specific factors rather than the market as a whole. For example, while internet stocks plunged, many other stocks did well. The mid-value stock actually made money during the bear market of 2000-02.

The net result was that the overall market was no more volatile than in previous decades. It simply took a lot more stocks to create a portfolio with such low volatility.

In contrast, during the 2008 financial crisis and the market crash in the early weeks of the Covid-19 pandemic, declines in stock prices were almost universal. Overall, market factors accounted for a larger share of total equity volatility. As a result, while a fully diversified portfolio still reduced volatility to market level, the bottom line was still more volatile than in previous decades.

Always worth a try

Given the results of this new research, is it less important than in the internet age to own many different individual stocks? No, according to Professor Lettau. Although overall market volatility has increased, “the level of stock-specific volatility, one that can be diversified by holding many stocks, has remained elevated, making diversification more important than ever,” the professor says.

You could even argue that diversification has become more important than before. Given that the overall stock market has become more volatile than in previous decades in US history, any additional volatility would be particularly difficult to bear. “Underdiversified portfolios are not only exposed to high market volatility, but also to avoidable stock-specific volatility,” adds Professor Lettau.

So how many different stocks should an investor own? It depends on how much volatility an investor is willing to endure, says Professor Lettau. But in general, 50 shares is still a good goal, he says. If investors don’t want to hold that many individual stocks, they should instead invest in a mutual fund or exchange-traded fund that contains at least that many.

Mr. Hulbert is a columnist whose Hulbert Ratings tracks investment newsletters that pay a fixed fee to be audited. He can be contacted at reports@wsj.com.

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