The Case for True Diversification--Searching for Alpha, October 2006

It’s been a long six years for investors in the Dow Jones Industrial Average. After a spectacular third quarter this year, the oldest index of U.S. stocks is now a breath away from the all-time high of 11,722.98 set on January 14, 2000.

The flat performance of such a well-known index is a bit disappointing, considering the hype about diversification we’ve all been forced to hear. In fact, considering the conventional wisdom that one can replicate the returns of the U.S. market with 10 to 30 stocks, one might think that a well-designed index of 30 leading domestic names would do better than post a break-even showing after six years.

As it turns out, all the studies (see Statman, M. “How many stocks make a diversified portfolio?” in the September 1987 Journal of Financial and Quantitative Analysis) that show the relative ease of capturing the return of the entire market with a few handfuls of equities have one thing in common–their use of the standard deviation of returns as the sole descriptor of risk. Unless one is capable of holding a much larger portfolio, one that could minimize the myriad economic risks to stocks that simply can’t be captured by its volatility of returns, investors have a good change of seeing the performance of their mini-index slowly drift away from the broader market.