Most effective way to avoid uncompensated risk is to invest passively.
This month's column continues the multipart series I began two months ago that explores active investing and passive investing within the context of modern prudent fiduciary investing.
Most Risk Can Be Diversified by Holding a Few Stocks
As I have noted a number of times, the 1994 Uniform Prudent Investor Act and the 1992 Restatement 3rd of Trusts (Prudent Investor Rule) place great emphasis on the duty to diversify. This is nothing new, though, since a basic provision of the 1974 Employee Retirement Income Security Act requires fiduciaries of corporate employee retirement plans such as 401(k) plans to discharge their duties "by diversifying the investments of the plan so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so."
It is often claimed that most risk of the overall stock market can be diversified away by holding, say, 40 or 30, or even just 10 stocks. For example, a booklet published by the American College of Trust and Estate Counsel, a group of the most elite estate-planning attorneys in the United States, states: "Empirical studies have shown that a small amount of diversification goes a long way. For example, it has been shown that a portfolio of 10 stocks provides 88.5% of the possible advantages of diversification. A portfolio of 20 stocks provides 94.2% of the advantages of diversification."
Other studies tell much the same story. For example, holding two stocks instead of one stock reduces uncompensated risk by 42% in a randomly selected portfolio. Holding six stocks instead of one stock reduces uncompensated risk by 71%, and holding 20 stocks instead of one stock reduces uncompensated risk by 81%.
Restatement Commentary also picks up on the claim that most risk of the overall stock market can be diversified away by holding relatively few stocks: "Significant diversification advantages can be achieved with a small number of well-selected securities representing different industries and having other differences in their qualities."
While this widely accepted claim is accurate, there is much more to the story. A surprisingly little-noticed four-page academic article published 30 years ago by a professor of finance who co-founded the Center for Research in Security Prices at the University of Chicago tells fiduciary and non-fiduciary investors the rest of that story.
In his article, Professor James Lorie observes that in any given year the expected return of a 50-stock portfolio isn't the same as the expected return of the overall stock market. The expected return of that portfolio will instead be within a potentially large range of returns falling around the market's return. For example, if the annual market return is 10% there's a significant chance statistically that the portfolio's return will fairly often differ as much as 4.5 percentage points above or below that return. In his example, a 50-stock portfolio could, therefore, return as little as 5.5% or as much as 15.5% in any given year.