The number of stocks required for effective portfolio diversification: the South African case

Abstract

This article considers several insights surrounding the number of stocks needed in portfolios in South Africa to achieve effective risk reduction. The majority of studies in the literature use equally-weighted portfolio construction schemes and conclude that at most 20 stocks are needed for effective diversification. We point out that more stocks are potentially needed in concentrated portfolios that typify portfolios in South Africa. To this end a market-capitalisation-weighting scheme is investigated and contrasted with an equal-weighting scheme in the construction of portfolios. Our findings confirm that more stocks are needed in the South African environment and we give recommendations for the number of stocks required to achieve effective diversification in South Africa.

Keywords:

• Diversification
• Concentration
• Number of Stocks
• Total Risk
• Active Risk
• Market Capitalisation Weights

Notes

1 The Herfindahl-Hirschman measure of concentration is computed using , where is the investment weights.