Diversification: How Much Is Too Much?

There should be adequate though not excessive diversification

Benjamin Graham, The Intelligent Investor (1949)

Diversification, the basic notion that one’s investments should be allocated across different assets to reduce risk exposure, is one of finance’s most intuitive and widely-accepted ideas. However, the optimal level of diversification is less obvious and the conventional wisdom on this question has evolved over time. Like other “good things”, diversification can become excessive because of associated transaction costs and because its risk-reducing marginal benefits diminish with portfolio size.

While it’s a good idea not to put all your eggs in one basket, don’t spend too much time looking for new and exotic baskets for your eggs.

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A Little History

When the Dow Jones Industrial Average (DJIA) was created in May 1896, it only included 12 stocks. As the number of public companies grew, the DJIA was expanded to 20 stocks in 1916, and then again to 30 stocks in 1928. During the first half of the twentieth century, 30 was generally considered the appropriate portfolio size. In describing proper diversification in 1949, Benjamin Graham wrote that “this might mean a minimum of ten different issues and a maximum of about thirty.” The classic graph that you can find in any finance textbook (see below) shows little risk reduction occurs after the first 30 stocks.

As the number of public companies continued to grow, it became more challenging to decide which 30 stocks one should own. In March 1957, Standard & Poor’s expanded its composite index to 500 stocks and the S&P 500 was born. In 1976, Vanguard launched the First Index Investment Trust, the world’s first index fund, giving investors low-cost access to a portfolio of all 500 components of the S&P 500. Afterwards, other mutual fund companies noticed the popularity of Vanguard’s product and rolled out their own S&P 500 index funds. Over time, the S&P 500 became the world’s most popular vehicle for stock investing and overtook the DJIA as the accepted benchmark for U.S. stock market performance.  

Still, investing solely in the S&P 500 misses out on several types of stocks. One such group is stocks of smaller companies. In a 1981 paper, Rolf Banz found that small-cap stocks had historically outperformed large-cap stocks, a result later confirmed in a famous 1992 paper by Eugene Fama and Ken French. In response, mutual fund companies started offering new funds focusing on small-cap stocks, and in 1992, Vanguard rolled out the Total Stock Market Portfolio to track the Wilshire 5000 Index, consisting of all stocks trading on major U.S. exchanges.

Another group not included in the S&P 500 are stocks of non-U.S. firms. Portfolio theory says that international diversification is even better than national diversification because it eliminates country-specific systematic risk (see graph below). As barriers to overseas investing came down, new mutual funds were introduced to enable investing in companies from different regions of the world. In 2008, Vanguard opened the Total World Stock Index Fund to give investors access to a low-cost globally-diversified vehicle.

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Analysis: How much diversification is enough?

With these different vehicles for achieving diversification, the natural question arises: How much diversification does one really need? Are the 500 large-cap stocks in the S&P 500 enough or is it better to invest in all U.S. stocks? What’s the gain from international diversification relative to national diversification?

No one would suggest taking a tiny stake in every single public and private firm in the world, because the costs would far exceed any diversification benefits

S&P 500 versus Total Market

I start by comparing the returns (gross of fees) of Vanguard’s S&P 500 index fund to its Total Stock Market index fund in the time period from May 1992 (when the latter fund became available) to December 2020. During this 28-year period, the average returns from investing in the entire stock market were slightly higher than those from the S&P 500 (see table below), consistent with the prior research on the superior performance of small-cap stocks. However, there is no risk reduction from the extra diversification in the total stock market index, as the S&P 500 actually had a slightly lower standard deviation of returns. At this point in time, the fee for investing in either index fund is the same at a very low 3 basis points per year.

Verdict: The Total Stock Market index is (slightly) better than the S&P 500 index; because small-cap stocks have historically earned higher returns, not because it’s less risky. Note: It’s possible that small-cap stocks will not outperform in the future.

Total Market (U.S.) versus World Market

Next, I compare the gross returns of Vanguard’s Total Stock Market index fund to its Total World index fund over the same time horizon. Because the latter fund was introduced in 2008, I assume it would have earned the returns of the MSCI World index prior to 2008. During the 1992-2020 period, the domestic index fund significantly outperformed the globally-diversified fund (see table below) by an average of 2.14 percentage points per year. This doesn’t mean that global diversification is a bad idea, just that U.S. firms happened to have a more successful recent run than foreign firms, a trend which may or may not continue into the future.  

Interestingly, there is no risk benefit from international diversification as both portfolios have almost identical standard deviation of returns. The global portfolio is also costlier to track, with a current annual expense ratio of 8 basis points, compared to 3 basis points for the U.S. portfolio.

Verdict: The Total Stock Market index is better than the Total World index. It is costlier to diversify internationally than domestically and there are no significant risk reduction benefits to doing so.

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Why is international diversification not that important anymore?

In theory, international diversification should be helpful for risk reduction, but there are several reasons why that is no longer the case in 2021. First, due to increased globalization, more American companies are multinational, doing business abroad and domestically, and the same is true of companies based in other countries. Therefore, investors are already getting a good deal of international diversification even if they only invest in domestic stocks. Second, the economic and financial links between countries ensure that there are no safe havens during a storm. The Asian currency crisis in 1997 caused stock markets everywhere to decline, and the same was true during the 2008 financial crisis which originated in the United States. Investors from smaller countries, where domestic economic or financial crises would not necessarily affect the global economy, might be able to protect themselves through global diversification. But this wouldn’t work for investors from large countries like the United States which play too large role a in the global economy.

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Conclusion

Like any good idea, diversification has its limits. No one would suggest taking a tiny stake in every single public and private firm in the world, because the costs would far exceed any diversification benefits. The evidence presented here suggests that going beyond the S&P 500 to invest in small-cap firms could slightly boost returns, while diversifying globally is increasingly not worth the effort. While it’s a good idea not to put all your eggs in one basket, don’t spend too much time looking for new and exotic baskets for your eggs.

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