If you could invest in the economy of the whole world ̶ the entire universe of all the world’s publicly traded and private companies ̶ would you?
An investment fund that owned a percentage of every company currently doing business in the world would represent the ultimate diversification. No doubt you would substantially reduce your risk through such radical diversification, but even if it were desirable, it is not attainable within the present financial services model.
What level of diversification is attainable? How many global large cap companies should you hold in a properly structured portfolio in order to maximize returns and reduce volatility? A recent study conducted by Dimensional Fund Advisors LP examined the probability of outperforming the market benchmark Morgan and Stanley Composite Index, All Country World Index (MSCI ACWI) over differing time horizons using sampled portfolios which held, on average, 50, 200, 500, 1,000 and 2,637 securities (1). They discovered that the probability of outperformance in the global large cap space increases substantially across all investment horizons as the number of stocks owned within the portfolios grows from 50 securities to full market coverage (i.e., 2,637 companies), as Figure 1 illustrates.
Over one year, a portfolio holding 50 securities has a 56.2% probability of outperforming the index. This compares to a 72% probability of outperformance with 2,637 securities, representing full market coverage. As the investment time horizon increases, the probability of outperformance becomes greater and the spread larger: the three-year probability holding 50 companies is 60% versus full market coverage of 86%; and the five-year probability of outperformance is 63% holding 50 companies versus 92% with 2,637 different securities.
Figure 2, which measures the average annualized volatility of portfolios holding varying numbers of securities, shows that volatility is reduced as the number of holdings increases.
Most investors sleep more soundly when their portfolios are navigating tranquil waters rather than taking on “surf’s up” waves. Less volatility also translates into more rational decision-making (i.e., not driven primarily by fear or greed), which in turn increases the likelihood of investors reaching their investment goals.
These simulations of various global large cap portfolios paint a clear picture of how the diversification offered by full market coverage can help investors achieve the twin goals of maximizing returns and minimizing volatility.
1) All simulated portfolios were constructed with the same exposure to the premiums as the Dimensional Country World Adjusted Large Cap Index in order to isolate the effects of diversification on performance reliability.
Source: Research Matters, a white paper written by WEI Cai, Ph.D. and Matt Wicker, CFA, of Dimensional Fund Advisors LP, April 18, 2018.
Dale Berg is a Senior Financial Advisor with Assante Financial Management Ltd. This material is provided for general information and is subject to change without notice. Every effort has been made to compile this material from reliable sources however no warranty can be made as to its accuracy or completeness. Please contact him to discuss your particular circumstances prior to acting on the information above. The opinions expressed are those of the author and not necessarily those of Assante Financial Management Ltd.