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© Copyright 2000 Rogers Media. The following article first appeared in the March 2001 edition of
BENEFITS CANADA magazine.
New rules of diversification
Market volatility has rendered the rule of 20 stocks obsolete. Your portfolio may be twice as risky
as it once was.
By Barbara Clapham
Having heard the saying 'don't put all your eggs in one basket' since childhood, most people grasp the concept
of spreading their money among different assets to reduce risk. Not long ago the general rule-of-thumb was that
investing in 20 different securities would reduce the total risk of a portfolio while enhancing potential
return. Diversifying beyond this number would not produce any further benefit.
"Thirty or 40 years ago in the U.S. market, a single randomly selected stock had a standard deviation 35
percentage points higher than a portfolio invested in an equally weighted index of all available stocks. A
portfolio of 20 individual stocks could reduce this excess risk to a modest level of about five percentage
points," explains John Campbell, professor of applied economics at Harvard University and managing partner,
research, at Arrowstreet Capital in Boston, Mass.
But now, this conventional wisdom has been challenged. "During the last decade, a single randomly selected
stock has had a standard deviation 50 percentage points higher than an equally weighted index, and it takes
a portfolio of 50 stocks to reduce excess risk to 5%," says Campbell. In other words, a portfolio
consisting of 20 securities now has excess risk of 10%--twice as much as before.
So what's changed in the past 10 years? Although the volatility of the overall market has not increased,
the volatility of individual stocks has been on an upward trend for some time now, says Campbell. A typical
stock is not only more volatile than before, but less correlated with other stocks. Campbell cites two
factors that have contributed to this change: the trend away from large conglomerates towards companies
focused on one or two key areas, and the tendency to list companies earlier in their life cycle when their
futures are less certain.
There have also been changes in the global environment that international investors should pay particular
attention to. Waves of country volatility associated with international crises have caused country
volatility to increase from 9% per year in the mid-1990s to roughly 12% in the last few years.
Within countries, sector volatility has followed suit. A few years ago, it was half of country volatility,
but today it's about the same, observes Campbell. It's not altogether clear why this has occurred but the
run-up in tech stocks, the subsequent collapse shifts in oil prices and changes in interest rates are
likely culprits.
Harry Gibbs, vice-president, investments, with the Workplace Safety & Insurance Board in Toronto,
encourages investors to look at what is going on within individual sectors. "I find it hard to swallow that
you just accept all stocks, good and bad, and buy the sector. It's good to have the talent to mine the
sector." Gibbs points out that this can be achieved through passive screening.
As for increased volatility, Gibbs thinks the huge volume and flow of information on the markets today is a
driving force behind this trend.
"We are still learning what is good news and what is bad data. Reacting to all of it creates a huge amount
of volatility." Because of this and other distinctive factors at play, Gibbs says it's helpful to keep in
mind that increased sector volatility may be a transient trend.
Trends aside, the changes in the markets in effect today have made attention to proper diversification
among companies, sectors and countries more important than ever. The good news is, this costs nothing. As
Campbell says, "diversification is a lunch that has not only remained free, but has grown more lavish over
the years." Just make sure you have some of every course.
Barbara Clapham is editor of Canadian Investment Review and a contributing editor to BENEFITS CANADA.
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CONFERENCES
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March 21 to 23, 2001
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