Portfolio diversification for long holding periods: how many stocks do Canadian investors need?

Abstract

The number of stocks required to achieve diversification has been under discussion for over four decades. Traditionally, it is viewed that between 8 to 20 stocks are adequate for a 'well' diversified portfolio based on American studies, and 30 to 50 stocks based on a Canadian study. The majority of the past literature has used American data with a focus on the short-term investment horizon. Cleary and Copp's (1999) paper is the only study that utilized Canadian data with an emphasis on the short-term investment horizon. To fill this void, this thesis examines the cumulative rates of return over a 20-year investment horizon by randomly investing $100,000 initially across 100 Canadian firms. The results of the simulation illustrate the probability distributions of the shortfall risks for individuals who own fewer than 100 stocks. To see if diversifying across industry groups reduces the shortfall risk faced by investors, a similar simulation is completed for investing randomly across Canada's four prime industry groups. The empirical results of this thesis suggest that the standard recommendation of 8 to 20 is inadequate for a long-term Canadian investor. More than 80 Canadian companies are required to obtain a shortfall risk amount of less than 5% ($57,929) of the 100-stock portfolio when investing randomly in Canadian companies. Note:Pages 35, 36, 39, and 40 contain numbers that have been cut off in the original thesis. This problem is not attributed to digitization of the document.