Investors rarely hold individual securities, but rather hold collections of secu

Question

Investors rarely hold individual securities, but rather hold collections of securities in various combinations called portfolios, typically in an effort to improve their diversification of that portfolio.

How many securities does it take to make a portfolio that can be considered to be as diversified as the overall market for those securities? In your answer, be sure to justify your answer from a financial and statistical standpoint.

Many mutual funds and investment portfolios contain hundreds, if not thousands, of individual securities in their portfolio.

Explanation / Answer

It is right to note that diversification increases with combination of securities having different features. However, it has nothing to do with number of securities.

The concept here is that by diversification, we are doing away with unsystematic risk inherent in particular securities as we are compensated only for the systematic risk that we take which cannot be diversified away and which is purely due to market conditions

Just to substantiate the point,if you take all securities from a particular industry say automobile then when the interest rates will rise in an economy , the consumers will not be able to afford more automobiles and hence the demand and resultantly the stock price will fall down. So in such a scenario, even if you have taken 100 different securities from automobile industry ,it will not make much difference as unsystematic risk (related to interest rate fluctuation) will still be there since all stocks will get affected ,though a stock of commercial vehicle manufacturer may be effected more than a stock of passenger vehicle manufacturer . But all will get effected and your returns as investor in these stocks will also suffer

However, if you take some securities of banking companies then increase in interest rates will help in increase in net interest income of the banks and thus , these stock will move upward and counter the decline in prices of automobile stocks. This will help in balancing the portfolio and doing away the unsystematic risk

Considering the above explanation, what is important is to combine stocks with different features rather than combining huge volume of stocks with same features

That is why stock market indices are considered to be reflecting the health of economy as they do not comprise stocks of all companies operating in that particular economy but they do combine securities with diffferent features which is sufficient to capture the beat of the market

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