Why building a lower-volatility equity portfolio has only got harder

Study shows reducing deviations in returns through additional stocks isn’t as easy as it formerly was

Why building a lower-volatility equity portfolio has only got harder

For investors, it’s more difficult than ever to diversify away volatility in their stock portfolios.

According to a report by the Wall Street Journal, researchers concluded that a stock portfolio has to contain at least 50 stocks to assure that its volatility is no higher than the market's overall volatility. This was around 22 years ago, at the top of the internet bubble.

That was a significantly higher number than in past decades, when as few as 15 stocks might have sufficed.

A 50-stock portfolio, on the other hand, would have had about the same amount of volatility, as the general market volatility hasn’t reflected much change since the early 1900s.

According to the researchers' most recent analysis, the situation has changed.

Over the last two decades, market volatility has increased significantly. While 50 stocks would still be sufficient to match a portfolio's volatility to that of the general market, investors would experience far more volatility than they could have accomplished with portfolio diversification prior to 2000.

Since you can’t diversify away today’s greater marketwide volatility, it is something “you just have to live with,” Martin Lettau, a professor at the University of California, Berkeley, and a co-author of the latest study, said about the investment implication.

“We got a taste of that greater volatility this past week, with the Dow Jones Industrial Average gaining 932 points on Wednesday [May 4] and then losing even more—1,063 points—on Thursday [May 5],” Lettau added. “If such volatility is too much for some investors to stomach, they will need to reduce their exposure to equities and invest more in asset classes such as bonds.”

The performance of equities during the three bear markets this century provides a solid illustration of diversification's limited potential. Rather than the market, stock-specific factors caused a large share of the market's overall volatility during the collapse of the internet bubble.

While internet equities were falling, many other stocks were gaining ground. During the bear market of 2000-2002, the typical value stock actually made money.

Share-price reductions were practically universal throughout the 2008 financial crisis and the market's drop in the early weeks of the Covid-19 outbreak. Overall market factors accounted for a larger portion of stock volatility.

As a result, while a fully diversified portfolio lowered volatility to market levels, the net result was still higher volatility than in previous decades.