Academic journal article Financial Services Review

Random Diversification over Time: The Case of Five European Countries Surrounding the Euro Introduction

Academic journal article Financial Services Review

Random Diversification over Time: The Case of Five European Countries Surrounding the Euro Introduction

Article excerpt

Abstract

This article adds to the financial literacy of active individual investors who restrict themselves to a limited number of securities. Using monthly observations and a sample size of up to 5,177 stocks from five major European equity markets, this study provides evidence that the marginal benefit of adding a random stock to a portfolio is time varying. Moreover, for small portfolios, the marginal diversification benefits are less pronounced during times of high volatility than during periods of low volatility. Further, while we show that the relative risk of European equity markets has increased after the introduction of the Euro, our study demonstrates that in the post-Euro period a smaller portfolio size is necessary to achieve the same percentage average relative risk reduction than in the pre-Euro period. The highest average relative risk reductions are obtained in the larger equity markets, where a random portfolio of 15 stocks yields an average relative risk reduction of close to 50% of a two-stock portfolio. Our study implies that most individual investors, who enjoy direct investing and, hence, restrict themselves to invest in a small number of securities to reduce transactions cost, may not be as irrational and underdiversified as commonly thought. © 2012 Academy of Financial Services. All rights reserved.

JEL classification: G11; G15

Keywords: Random diversification; European equity markets; Euro conversion; Small portfolios

(ProQuest: ... denotes formulae omitted.)

1. Introduction

With the exception of a few countries, most industrialized countries face the challenge of a growing population of retirees in combination with a shrinking population entering the workforce. This shift in demographics is putting future social security benefits in jeopardy and requires younger individuals to invest more for retirement. This in turn demands that individuals obtain a certain level of financial literacy, especially with respect to benefits from diversification.

The lack of financial literacy is stressed and discussed in studies such as Mandell and Schmid Klein (2007), Volpe, Chen, and Liu (2006), and Chen and Volpe (1998). This article tries to add to the financial literacy of active individual investors who restrict themselves to a limited number of securities by investigating the benefits from random diversification in major European equity markets surrounding the introduction of the Euro. Addressing benefits from random diversification in non-U. S. equity markets to enhance financial literacy among active individual investors may be important, because Kyrychenko and Shum (2009) find that lack of financial sophistication, especially the awareness with respect to diversification benefits, is negatively correlated with allocation of funds towards foreign stocks.

Financial literature has long recognized that total risk decreases as stocks are added to a portfolio. This process is driven by the imperfect correlation among stock returns and the risk reduction occurs at a decreasing rate (e.g., Evans and Archer, 1968; Fama, 1976; Gup, 1983; Stevenson and Jennings, 1984; Reilly, 1985; Francis, 1986; Statman, 1987). Hence, modern portfolio theory assumes that investors hold well-diversified portfolios, which is easily accomplished by individual investors through indirect investments in mutual funds. With respect to indirect investing, Fortin and Michelson (2002) show that on average, with the exception of small company equity funds and international stock funds, indexing provides higher returns than actively managed funds, even after considering taxation. In contrast to United States based mutual funds, Fortin and Michelson (2005) demonstrate that, with the exception of European funds, actively managed international mutual funds outperform the index funds.

Nevertheless, the literature shows that small individual investors are highly underdiversified and invest only in a very limited number of stocks (e. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed

Oops!

An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.