New Study Shows Investors' Portfolios Are Under-Diversified

hile investors understand that they should diversify their investment portfolios, researchers have found that the vast majority of investors fail to do so, considering the task of implementing and maintaining a diverse portfolio to be daunting.

William Goetzmann of Yale School of Management and Alok Kumar of Cornell University Department of Economics examined the portfolios of 40,000 equity investment accounts held at a large discount brokerage firm during a six-year period (1991-1996). Their research paper may be found on the Internet at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=287998.

The investor database upon which the study is based had an aggregate value of $2.5 billion at any given time. The average account size is $35,629. Investors hold stocks an average of 187 trading days and the average portfolio turnover rate is 7.59%, indicating that buying and selling is infrequent. It also is clear, the researchers found, that investment portfolios heavily are tilted towards technology and consumer companies. Dominating the lists of the 20 most widely held and 20 most actively traded stocks are stocks such as: IBM, Microsoft, General Motors, General Electric and Coca Cola. The performance of these stocks tends to be correlated with each other, which causes the researchers to comment that investors have adopted a "naïve" (and ineffective) diversification strategy.

Most troubling to the researchers is the fact that only 5-10% of investors hold more than 10 stocks. An average investor holds only a 4-stock portfolio, 50% of investors hold 2 stocks and 25% of investors hold 1 stock. The researchers write that it commonly is believed that a well-diversified portfolio should consist of at least 10-15 stocks, as a conservative estimate (another researcher estimates that the number of stocks should be 30 for proper diversification).

The bottom line is that this lack of diversification, as well as the high correlation between the returns of the few stocks chosen, results in increased risk exposure. In fact, the researchers find that the risk exposure of investor portfolios is significantly higher that the risk exposures of randomly chosen portfolios or benchmark portfolios.

As stated earlier, investors are aware of the benefits of diversification or, in the vernacular, not putting "all of their eggs in one basket". But proper execution of the strategy does not occur. So what are the causes of this imprudent investor behavior?

The researchers found that investors in low income and non-professional categories of their sample hold the least diversified portfolios. Likewise, the study concludes that young, active investors are over-focused and tend to hold under-diversified portfolios. In sum, the researchers find that a significantly large group of investors in their sample believe that they can earn superior performance by active trading and that they choose not to hold a well-diversified portfolio. Thus, the imprudent investor behavior discussed results from an inappropriate degree of over-confidence, which may arise from an "illusory sense of control" that the investors may develop due to their direct involvement in the investment process and due to their familiarity with a certain, small set of stocks. In effect, these investors consider the task of implementing and maintaining a truly diverse portfolio to be daunting, and hence avoid doing so.

The Goetzmann and Kuman study certainly shows that many investors would be well advised to broaden their investment portfolios, perhaps with the assistance of a competent financial adviser. For less risk, and better performance, investors need to do more than pay lip service to the diversification concept.