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December 9, 2004, at 4:45 p.m.
University Events Room
Glickman Family Library, 7th floor
Portland USM Campus (map)

One of the most widely-accepted principles in investments is that of portfolio diversification, whereby exposure to firm-specific risk is reduced or eliminated by allocating capital across securities. One of the most widely-cited diversification "facts" is that portfolios can be effectively diversified via the holding of a relatively small number of securities. Early studies, for example, suggest that near-complete diversification can be achieved in portfolios composed of as few as 10-15 securities. More recent studies suggest that managers can effectively eliminate firm-specific risk by holding 50 or so randomly-chosen securities. In this work, we demonstrate that while this may be true on average, individual portfolios are likely to contain significant amounts of firm-specific risk, even when composed of large numbers of securities. For example, we find that an investor holding a portfolio of 300 stocks can expect to eliminate 95% of firm-specific risk on average. At the same time, however, the likelihood that firm-specific factors will cause this investor's returns to deviate from average returns by at least 250 basis points is over 40%! Our results suggest that firm-specific risk might properly be viewed as non-diversifiable, and that believing a portfolio is sufficiently diversified because it holds some sufficient number of securities is similar to believing one can walk across a river with an average depth of 6 inches.
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James Bennett is an Assistant Professor of Finance at USM. He earned his doctorate from the University of Texas and has taught (in reverse chronological order) at the University of Massachusetts Boston, Otago University in Dunedin, New Zealand, and the Chinese University of Hong Kong. His primary areas of research are asset pricing and investment management. He has published articles in The American Economic Review, Financial Analysts Journal, and The Review of Financial Studies. Professor Bennett has held the CFA designation since 1999.

The colloquium is sponsored by the L.L. Bean/Lee Surace Endowed Chair in Accounting.

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USM Professor Jeffrey Gramlich was appointed the first L.L. Bean/Lee Surace Chair in Accounting in the USM School of Business in 2003. His appointment was made possible by a $1 million gift from L.L. Bean, Inc., its board chair, Leon Gorman, his wife Lisa, Jim and Maureen Gorman, and Tom Gorman, who established the chair in memory of L.L. Bean CFO Lee Surace '73, '81, who died in March of 2001. Surace was chair of the USM School of Business' Advisory Council and was a frequent guest lecturer.

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