This issue has three parts. The Security Market Line ties the expected return on

Question

This issue has three parts.

The Security Market Line ties the expected return on stocks to the systematic nondiversifiable risks. The development of the model usually references studies indicating that investors holding as few as 15 stocks effectively reduce the risk of the portfolio down to the systematic level. The compensation for the risk in investment is related to the risk associated with only the element of risk that cannot be diversified away

The Efficient Frontier article, “The 15-Stock Diversification Myth,” (seehttp://www.efficientfrontier.com/ef/900/15st.htm) discusses results of a recent study on stock variability and diversification. The study by Burton Malkiel in a recent Journal of Finance is summarized in the article along with extended studies by William Bernstein, the author of efficient frontier.

After reading the article answer the following questions:

1. What did Malkiel’s study of individual stock volatility, correlation of stock returns and overall market volatility show?

2. What are the implications for diversification from these findings?

3. The article also looked at super stock performance and terminal wealth dispersion, as well as systematic standard deviation to measure standard deviation. The measure of terminal wealth dispersion incorporates the impact of variation on the wealth of an investor after investing for a long number of years. What was Bernstein’s main conclusion concerning the diversification and the number of securities that would be required to be held?

Explanation / Answer

Answer: The findings of Malkiel’s study showed that the volatility of individual securities has increased significantly over the last 40 years. At the same time, the overall volatility of the market hasn’t increased.That result is explained by the fact that the correlations of individual stock returns have fallen over the last 40 years.The lower correlation cancels out the effect of increased individual volatility when stocks are formed into portfolios.

Answer: 2.While overall market volatility is not higher, the higher individual variabilityand lower correlations do not necessarily translate into the same number of securities required to eliminate systematic or market risk. In later periods, it took a much larger number of securities to reduce total risk to the systematic risk level. The effect is quite dramatic, as shown on the “Panel B” graph.

Answer:3 The conclusions by Bernstein indicate that, while it is possible to reduce systematic risk levels significantly with as few as 30 securities, reduction ofsystematic risk may only be a small part of the puzzle when you areevaluating investment performance.You may need to concentrate on how dispersed your terminal wealth from investment may be. He concludes that while a portfolio with 30 stocks may reduce the unsystematic risk to acceptable levels, you may need to buy very large numbers of securities to reduce dispersion of your wealth position. His final conclusion states that the only way to truly minimize risk from investment may be to own the wholemarket.

He demonstrates this point by forming a 100 equally weighted stock portfoliosfor 10-year holding periods. The terminal wealth differences for the portfolios are much larger than expected.Three fourths of the portfolios were below the market average return as measured by the S & P 500 Index.The market averages over that period were heavily influenced by a few super stocks suchas Dell.If the portfolio did not contain the super stocks, the portfolios underperformed the market.The article points out the difficulties in assessing the impact of many risk factors in stock investing. While most of the systematic risk is removed with a relatively small number of stocks, terminal wealth is much too diverse.

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