The changing landscape of diversification in finance is evident in recent trends, such as increasing stock market concentration and the complexities introduced by global economic dynamics.
Historically, diversification gained traction with the advent of modern portfolio theory, which emphasized the importance of including assets with low or negative correlations to achieve optimal risk reduction.
However, the dominance of U.S. equities in global markets and the rise in concentration pose challenges for effective diversification. As stock markets become more concentrated, the ability to diversify effectively diminishes, raising questions about the efficacy of traditional diversification strategies.
While diversification is a powerful tool, it should not be pursued indiscriminately. Overdiversification can dilute the potential benefits of insights or information and hinder the potential for outperformance.
The evolution of globalization has also impacted diversification strategies, allowing for greater cross-border investment and the rise of low-fee passive investment vehicles.
Determining the optimal number of stocks for effective diversification is a critical consideration, as research has shown that even with a portfolio of 100 stocks, the tracking error remains substantial.