Rational investors diversify. Through diversification an investor can eliminate the risk that goes with investing in a single stock without any sacrifice of expected return. Studies indicate that one can eliminate more than 99% of company-specific risk with a portfolio of as few as twenty stocks. And with 200 to 300 stocks all company-specific risk is gone. The only risk that remains is market risk -- the risk that the market as a whole will rise or fall.
Moreover, investors have no real choice but to diversify. The fact that company-specific risk can be avoided means that the market sets the price of individual securities as if no such risk exists. To see why, suppose that market prices did reflect company-specific risk. Portfolio investors would buy up securities -- which would be underpriced from their point of view -- and hold them in portfolios that eliminate company-specific risk. The price of stocks would rise and eliminate any return attributable to company-specific risk. Undiversified investors would then be forced to pay higher prices for individual stocks even though the return remained the same. In other words, an investor who buys a single stock as a stand-alone investment takes more risk than is necessary to achieve the expected return from that single stock. Such behavior in an investor who is able to diversify is irrational by definition, because the fundamental goal of investing is to generate the greatest possible return at the lowest possible risk.
Finally, it is virtually costless to diversify. Although it might at first seem as if only the very wealthy can afford to hold as many as 200 or 300 stocks, complete diversification is available very cheaply through mutual funds for investors with as little as $1000 to invest. In short, it is so cheap and easy for investors to diversify that it is simply unnecessary for investors to take company-specific risk. There is no downside to diversification. Accordingly, a rational investor must diversify. By the same token, it is fair to say that it is irrational for an investor who can do so not to diversify.
You've explained very well why the average investor with no information should fully diversify. But I think you're going too far by saying that it is irrational for anyone to ever be less than fully diversified. What if an investor believes that a particular stock or industry is undervalued? Diversifying away that individual or industry risk may be very costly and suboptimal in that case.
To argue that all rational investors must at all times be fully diversified, you need to argue that no investor ever has information. But then how does "the market" get information? Do you know of any model that predicts that prices will be efficient even though no investor ever trades on information? Noiseless models with endowed information don't count, since they're clearly unrealistic for this purpose. Have you seen a model where it takes time and effort to figure out how much a stock is worth, and yet prices are always efficient even though no one ever puts in that time and effort? Does this make intuitive sense?
If you're just giving general advice for the average retail investor, that's fine. I agree with the idea that small retail investors in general don't have the resources or the training to compete with institutional investors (although they still might choose to invest in and follow a few stocks, if they enjoy it; this might be rational in the sense of utility-maximization). But you seem to be arguing that all rational investors must always be fully diversified, and I don't understand how this can work in practice.
Posted by: Ann | January 31, 2006 at 01:17 PM
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