Portfolio Diversification and Risk Reduction- Evidence from Taiwan Stock Mutual Funds

Abstract

The relationship between portfolio performance and the number of stocks held in the portfolio has long been of interest to many financial economists ever since Markowitz (1952 and 1959) proposes his modern portfolio theory. Markowitz describes how portfolio risk can be effectively reduced by infinitely increasing the number of assets held in the portfolio. Although portfolio diversification is generally accepted by practitioners and academicians, overdiversification can potentially incur marginal costs for several reasons. The study argues that in the presence of the costs of overdiversification, there exist optimal stock holdings in which portfolio return could be effectively maximized and portfolio risk could be efficiently minimized without holding infinite number of assets. Earlier studies exploring the problem of optimal portfolio size mostly focus on how many stocks are sufficient to make an efficient portfolio. Based on the ordinary least square method (OLS) and generalized autoregressive conditional heteroscadesticity model (GARCH) on the data of Taiwan stock mutual funds, we find that the optimal portfolio size in terms of the number of stock holdings could be between 21 and 24 with portfolio returns maximized and volatility minimized. Contrast to conventional studies in portfolio diversification, we verify that overdiversification may just offset the benefits from diversification, shedding light on deriving effective investment strategy for portfolio managers.