diversification a bigger free lunch

diversification a bigger free lunch - Diversification: A...

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Diversification: A Bigger Free Lunch John Y. Campbell Managing Partner, Research, Arrowstreet Capital, LP and Otto Eckstein Professor of Applied Economics, Harvard University July 7, 2000 Economists are famous for pronouncing gloomily that “there’s no such thing as a free lunch”. Yet finance theory does offer a free lunch: the reduction in risk that is obtainable through diversification. An investor who spreads her wealth among many investments can reduce the volatility of her portfolio, provided only that the underlying investments are imperfectly correlated. There need be no reduction in average return and thus no bill for the lunch. Many investors appear to ignore this free meal. They overinvest their retirement savings in the company they work for, in one or two favored sectors such as technology, and in companies that are based in the region where they live. (An amusing example is the tendency of US investors to buy the stock of their local telephone company). Even sophisticated investors concentrate their portfolios in stocks of their own country rather than diversifying internationally. Perhaps such investors feel that the volatility reduction provided by diversification is small; the free lunch is so meagre that it is not even worth lining up at the buffet table. In fact the benefits of diversification are substantial, and they have grown dramatically over time. Thirty or forty years ago in the US market, a single randomly selected stock had a standard deviation 35 percentage points higher than a portfolio invested in an equally weighted index of all available stocks; a portfolio of 20 individual stocks could
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diversification a bigger free lunch - Diversification: A...

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