How diversifiable is firm-specific risk?

James Bennett and Richard W. Sias*

October 20, 2006 JEL: G10, G11, G12, G14 Keywords: diversification, idiosyncratic risk

Bennett is from the Department of Accounting and Finance, University of Southern Maine, Portland, Maine 041049300, (207) 780-4080, james.bennett@maine.edu. Sias is from the Department of Finance, Insurance, and Real Estate, College of Business and Economics, Washington State University, Pullman, Washington, 99164-4746, (509) 335-2347, sias@wsu.edu. The authors thank Jack Bogle, Mark Hulbert, Harry Markowitz, Meir Statman, Harry Turtle, David Whidbee, and seminar participants at the Inquire UK Fall 2006 conference, Washington State University, and University of Southern Maine for their helpful comments. Copyright 2006 by the authors.
*

How diversifiable is firm-specific risk?

Abstract Contrary to conventional wisdom, we demonstrate that: (1) there is no evidence investors can, or have ever been able to, easily form a well-diversified portfolio, and (2) there are, and always have been, substantial diversification gains available beyond a relatively small portfolio (e.g., 20-50 stocks). Investors ability to eliminate firm-specific risk is, in fact, much more limited than previously recognized. In recent years, for example, one-fifth of randomly-chosen 50-stock portfolios experienced, on average, an annual firm-specific shock of 16%.

How diversifiable is firm-specific risk? 1. Introduction This study re-examines two fundamental questionshow large must a portfolio be to ensure negligible firm-specific risk? And, at what point do gains from additional diversification become meaningless? Our analysis yields surprising answers. Contrary to conventional wisdom, there is no evidence investors can, or have ever been able to, form well-diversified portfolios and there are, and always have been, substantial diversification gains from holding much larger portfolios than traditionally recommended. A portfolio is well-diversified when an investor is assured that the portfolios firm-specific return will differ negligibly from zero (Ross, 1976). Determining the number of securities required to form such portfolios is fundamental to financial economics because of the central role well-diversified portfolios play in market efficiency, portfolio management, and asset pricing theories. These theories rely, at least in part, on arbitrageurs to risklessly correct mispricings and ensure that only systematic exposures are priced. The idea that investors can easily eliminate firm-specific risk is ingrained and pervasive. Alexander, Sharpe, and Bailey (2001, pages 163 and 216), for example, note, Roughly speaking, a portfolio that has equal proportions of 30 or more randomly selected securities in it will have a relatively small amount of unique risk. Its total risk will be only slightly greater than the amount of market risk that is present. Such portfolios are well diversified and For a well-diversified portfolio, nonfactor risk will be insignificant. Similarly, Francis and Ibbotson (2002, page 399) maintain, Diversifiable risk may be easily diversified away to zero in a portfolio that contains more than about 36 random stocks because the unsystematic pieces of good luck and bad luck from randomly selected assets tend to average out to zero. The Securities Exchange Commission (2005) tells investors that, Youll need at least a dozen carefully selected individual stocks to be truly diversified. Campbell, Lettau, Malkiel, and Xu (2001) suggest, however, that the decline in the average correlation between stocks and the rise in firm-specific risk over time has increased the number of securities needed for a well-diversified portfolio. The 2003 edition of Malkiels classic A Random Walk Down Wall Street, for instance, maintains the golden number has increased to 50.

The widely-accepted belief that investors can easily eliminate firm-specific risk and there are effectively no gains to diversification beyond a relatively small portfolio appears to be largely based on the erroneous interpretation of the relation between the number of securities in a portfolio, the expected standard deviation of the portfolio, and the return standard deviation of the market portfolio. For example, the most widely used textbook (Brealey, Myers, and Allen, 2006) in the top MBA programs (see Womack, 2001) shows a graph analogous to Fig. 1, and reports, In Figure 7.9 we have divided risk into two partsunique risk and market risk. If you have only a single stock, unique risk is very important; but once you have a portfolio of 20 or more stocks, diversification has done the bulk of its work. For a reasonably well-diversified portfolio, only market risk matters. Most finance textbooks contain a similar graph and interpretation. [Insert Figure 1 about here] The problem with Fig. 1 is that it does not, and cannot, divide total risk into systematic and firmspecific components. A portfolios total variance is the sum of its systematic and firm-specific variances. A portfolios standard deviation, however, is not the sum of its systematic and firm-specific standard deviations. Consider a simple numerical example of what this mistake means. Assume that the return standard deviations for the market portfolio and a given N-asset portfolio are 4% and 5%, respectively. Fig. 1, therefore, erroneously suggests firm-specific risk for the given N-asset portfolio is 1% when, in fact, the portfolios firm-specific risk is 3%, i.e., although 52=42+32, 54+3. Fig. 2 demonstrates how this error impacts estimates of firm-specific risk in practice. Specifically, Fig. 2 plots the relation between the number of securities in a portfolio and expected annual total risk, market risk, and firm-specific risk (estimated over the 2000-2004) for portfolios of 10 to 500 securities. As shown in Fig. 2, total standard deviation is not the sum of market and firm-specific standard deviations. Denoting the difference between total risk (the top line) and market risk (the broken line) as firm-specific risk is analogous to denoting the difference between total risk (the top line) and firm-specific risk (the bottom line) as market risk. A portfolio is well-diversified when the bottom line (expected firm-specific risk) is negligibly different from the horizontal axis. The fact that total risk (the top line) and market risk (the broken line) are close, does not imply that a portfolio is well-diversified (i.e., that the bottom line is negligibly different from the

horizontal axis). Because an arbitrageur, by definition, takes long and short positions in portfolios with equal systematic exposures (and therefore perfectly hedges the systematic risk), the difference between the total risk of an N-stock portfolio and that of the equal-weighted market portfolio is meaninglessall that matters to an arbitrageur is the uncertainty regarding the firm-specific shocks.1 [Insert Figure 2 about here] Consider, for example, the risk faced by an investor attempting to exploit an arbitrage opportunity with 50-stock portfolios. In recent years (2000-2004) the expected annual return variance for a 50-stock portfolio was 4.36% (consisting of, approximately, an equal-weighted market variance of 3.58% plus firmspecific variance of 0.78%). Because firm-specific and systematic shocks are independent, an investor holding the typical 50-stock portfolio had only moderately greater total return uncertainty than an investor holding the market portfolio. As shown in Fig. 2, the average 50 stock portfolio had a 20.9% annual return standard deviation ((0.0358+0.0078)) versus 18.9% (0.0358) for the market portfolio. The relatively small difference in total return uncertainty, however, does not mean firm-specific uncertainty is smallthe fact the two distributions have similar parameters (i.e., same mean, similar standard deviations) and are inherently related (i.e., the expected systematic returns on a randomly-selected 50-stock portfolio and on the market portfolio are equal) does not imply that a draw from one distribution will differ only slightly from a draw from the other distribution. Specifically, the expected annual firm-specific variance of 0.78% for a 50-stock portfolio means the average 50-stock portfolio has a firm-specific standard deviation of 8.8% (0.0078). Thus, the arbitrageur actually faces substantial firm-specific riskmost of the time, at least one of the arbitrageurs 50stock portfolios would experience a firm-specific shock of at least 8.8%.2

Moreover, for most other (i.e., non-arbitrageurs) investors, idiosyncratic risk is likely to be more important than the difference between total return uncertainty for a portfolio and return uncertainty for the market. Professional managers who account for most trading (e.g., Schwartz and Shapiro, 1992), for example, are nearly always judged on their performance relative to market indices. Thus, most professional investors likely care more about the uncertainty regarding deviation from systematic returns than the total return uncertainty [see Waring and Siegel (2006) for further discussion]. Similarly, it is reasonable to hypothesize that many individual investors also focus on deviations from market returns given evidence that individual investors chase mutual funds that experience positive firm-specific shocks (e.g., Gruber, 1996). 2 By definition, the arbitrageur has net systematic exposures equal to zero. Thus, the expected standard deviation of the un-hedged portion of each portfolios return is 8.8%. Because the firm-specific shock of each portfolio is independent of the other, the likelihood that at least one portfolio has a firm-specific shock of at least 8.8% is 54% i.e., 1-0.682 (assuming the distribution is normal).
1

Similarly, the fact that most gains from diversification occur with the first few securities does not imply that the gains to further diversification are effectively meaningless. For example, under the same set of assumptions, an investor holding arbitrage portfolios each consisting of 200 stocks faces only one-half the firm-specific risk as the 50-stock arbitrageur, i.e., the expected firm-specific standard deviation of a 200-stock portfolio is 4.4% versus 8.8% for a 50-stock portfolio. Although the gains from additional diversification are small relative to the gains associated with the first few securities, they can be substantial in absolute terms. That is, the bottom line in Figure 2 reveals that there is room for substantial diversification gains beyond a relatively small portfolio. A second problem with interpreting a 50-stock portfolio as well-diversified is that the relation between the number of securities in a portfolio and expected portfolio risk is misleading because it fails to account for the distribution of possible volatilities around the expected value. For example, the firm-specific risk for (approximately) half of all 50-stock portfolios will be greater than the expected firm-specific risk. Thus, as Elton and Gruber (1977) point out, diversification gains associated with larger portfolios arise from both a decline in the expected firm-specific risk and from greater confidence in that estimate. Given one cannot evaluate the difference between the expected standard deviation of an N-asset portfolio and the market portfolio to determine when a portfolio is well-diversified, one must either: (1) focus on variance, because unlike standard deviation, expected variance is the sum of firm-specific and systematic variance, or (2) focus on the role of firm-specific and systematic risk in explaining cross-sectional variation in portfolio returns. We take both approaches, but demonstrate key benefits to focusing on the latter. First, unlike variance, the relative role of firm-specific risk in explaining cross-sectional variation in portfolio returns is large and constant, i.e., it does not decline with the number of securities added to the portfolio. If firmspecific risk, for example, accounts for 90% of the cross-sectional variation in individual security returns, then firm-specific risk will also account for 90% of the expected cross-sectional variation in the returns of randomly-chosen portfolios of any given size. Because the relative role of firm-specific risk in explaining crosssectional return variation is constant, one can easily determine if N assets are sufficient for a well-diversified portfolio by simply computing the return variation across randomly-chosen N-security portfoliosif the

cross-sectional portfolio return variation is non-negligible, then firm-specific risk is also non-negligible and N assets are insufficient for a well-diversified portfolio. Second, because the relative role of firm-specific risk in explaining cross-sectional variance in portfolio returns is independent of portfolio size, conclusions regarding investors ability to form well-diversified portfolios are unlikely to be explained by errors in decomposing returns into systematic and firm-specific components. As long as firm-specific shocks account for most of the cross-sectional variation in individual security returns, then non-negligible return variation across random Nasset portfolios indicates that N assets are insufficient to ensure a well-diversified portfolio. Our empirical results demonstrate that even very large portfolios have substantial firm-specific risk. In recent years, one in five investors who held an equally-weighted random 200-stock (500-stock) portfolio, for example, averaged an annual firm-specific shock of 7.8% (4.7%). Although we focus our analysis on a recent five-year period (2000-2004), we also show that both small (e.g., 20 stocks) and large portfolios (e.g., 500 stocks) have never been well-diversified (at least as far back as 1966). In sum, contrary to conventional wisdom, we find no evidence that investors can form portfolios with negligible firm-specific risk or that there is ever a point where the diversification gains from holding a larger portfolio are not statistically significant. Our conclusion is, of course, predicated on ones definition of negligible. As noted above, for example, one in five randomly-selected 500-stock portfolios averaged an annual firm-specific shock of 4.7%. We maintain that if one assumes the expected risk premium on a randomly-selected portfolio is approximately 6% per year, a one-in-five chance of averaging a 4.7% firm-specific shock indicates that the investor is not assured of a firm-specific return that is negligibly different from zero. Because investors ability to eliminate firm-specific risk through diversification is a central tenet of asset pricing, market efficiency, and portfolio management theories, our results have a number of implications. First, investors inability to exploit mispricing without significant exposure to firm-specific risk (i.e., their inability to form arbitrage portfolios) suggests that observed returns may differ from those predicted by asset pricing theories by more than previously anticipated. This may help explain the persistence of some anomalies and the possibility of bubbles in asset prices. Second, if firm-specific risk is not easily diversifiable, then it may be priced (see Mayers, 1976; Levy, 1978; Merton, 1987; Barberis and Huang, 2001;

Malkiel and Xu, 2002; Goyal and Santa Clara, 2003). Third, managers holding relatively large portfolios may not be closet indexerseven large portfolios with total risk only slightly greater than market indices may have substantial firm-specific exposures. Fourth, investors portfolios are not nearly as well-diversified as they have been led to believe. There are, and always have been, substantial and statistically significant diversification gains from holding much larger portfolios than traditionally recommended.

2. The role of firm-specific risk in portfolio return and variance Define the excess return on security i in period t as the securitys return less the risk-free rate (i.e., Rit = rit - rft) and assume that security returns are generated by a linear K-factor model with the following properties: firm-specific shocks have an expected value of zero (E(i)=0), finite variances (( E( i2 ) = 2 ( i ) > 0 ), are independent across securities (E(i,j)=0), are independent from systematic factors

(E(i,k)=0 i,k), and are independent over time (E(it,it-1)=0):

R it =

k =1

ik kt

+ it .

(1)

The return on a portfolio is the weighted average return of the securities in the portfolio (where wi is the fraction of the portfolio invested in security i): R pt =

w R =
i it i =1 k =1

pk kt

+ pt , where pk = w i ik k , and pt = w i it .
i =1 i =1

(2)

The expected portfolio return variance in this framework is given by:

K E 2 R p = E 2 pk k + E 2 p . k =1

( ( ))

( ( ))
it

(3)

For an equal-weighted portfolio, pt = shocks is:

1 N

i =1

, and the expected variance of the portfolios firm-specific

E2 p =

( ( ))

1 E 2 ( i ) . N

(4)

Eq. (4) demonstrates that, as is well-known, as N approaches infinity, the variance of firm-specific shocks approaches zero, and thus, given the expected firm-specific shock is zero, an investor can be certain that the firm-specific return will be zero (i.e., the portfolio is well-diversified). Although examination of diversification as the expected fraction of firm-specific risk eliminated is independent of the level of firm-specific risk (i.e., the expected firm-specific variance of a randomly-selected N-asset portfolio is 1/Nth that of holding a single randomly-selected security), estimation via Eq. (4) of the level of firm-specific return uncertainty contained in an N-security portfolio requires an estimate of the expected variance of firm-specific returns at the individual security level, i.e., E( 2 ( i )) .

2.1. Estimates of expected firm-specific risk of a single security The expected variance of firm-specific shocks for a single (randomly-selected) security (i.e., E( 2 ( i )) in Eq. (4)) can be estimated by averaging the individual estimated firm-specific variances for each security across all M securities in the market (see Appendix A for proof). Letting E( 2 ( i )) indicate the 2 estimated expected variance of a single randomly-selected security and TS ( i ) denote the estimated timeseries firm-specific variance for security i:

1 E 2 ( i ) = M

( ).
2 TS i i =1

(5)

Alternatively, because the expected variance of a single randomly-selected security is simply the variance of the distribution of firm-specific shocks pooled over all securities, the cross-sectional variance of observed firm-specific shocks is also an unbiased estimate of the expected variance of firm-specific shocks for a randomly-selected security, i.e., E( 2 ( i )) in Eq. (4) (see Appendix A for proof). Letting 2 XS ( i ) denote the estimated cross-sectional firm-specific variance in security returns: 2 E 2 ( i ) = XS ( i ).

(6)

2.2. Time-series and cross-sectional variation in random portfolios

The expected time-series variance of a randomly-selected N-asset portfolio can be written as (see Appendix A for proof):
K K N 1 K 1 1 2 2 2 E TS R p = E TS ik k + E cov TS ik k , jk k + E TS ( i ) , (7) N N N k =1 k =1 k =1

( ( ))

where the TS subscript indicates the time-series variance and covariance. The sum of the first two terms in Eq. (7) is the expected systematic risk of a randomly-selected N-asset portfolio (i.e., the first term on the right-hand side of Eq. (3)) while the last term in Eq. (7) corresponds to the expected firm-specific risk for a random N-security portfolio (i.e., Eq. (4) or the last term in Eq. (3)). As noted in the introduction, because firm-specific risk is manifested as deviations from systematic returns, one may examine cross-sectional return variation on randomly-selected N-asset portfolios to evaluate the relation between the number of securities in a portfolio and firm-specific risk.3 The intuition is straightforwardportfolio (or security) returns differ only because the portfolios exhibit different systematic exposures or because the portfolios receive different firm-specific shocks. Because the number of assets is finite, however, the expected cross-sectional return variance across random portfolios will decline with portfolio size (regardless of the level of firm-specific risk) due to overlap in constituent securities across portfolios. For example, once portfolio size exceeds half the number of securities in the market, any two portfolios must hold common securities. In the case of equal-weighted portfolios formed from a finite pool of securities, the expected cross-sectional return variance can be written as a function of the portfolio size

Several previous studies suggest using cross-sectional return variation to examine diversification. Solnik and Roulet (2000) develop a direct link between time-series correlation between two assets (in their case, international markets) and the cross-sectional variation in asset returns. Similarly, de Silva, Sapra, and Thorley (2001) argue that cross-sectional variation in mutual fund returns increases over time because the cross-sectional variation in stock returns increases over time. In fact, Eq. (5) in de Silva, Sapra, and Thorley (2001) is similar to the last term in Elton and Grubers Eq. (B18) and our Eq. (8). In a study of mutual fund diversification, ONeal (1997) examines the dispersion of terminal wealth values for portfolios of mutual funds (see also Fisher and Lorie, 1970). In a concurrent working paper, Statman and Scheid (2004) argue that the cross-sectional standard deviation of total returns is a more intuitive measure of diversification than time-series correlation. Although these studies usually define the cross-sectional standard deviation of returns as dispersion, we avoid that term because, as we demonstrate (in Appendix A), both the cross-sectional variance of firmspecific shocks and the cross-sectional average of the time-series variance of firm-specific shocks generate estimates of the expected variance of firm-specific shocks for a randomly-selected security, i.e., both are estimates of the same quantity. In addition, although firm-specific shock dispersion is an unbiased estimate of firm-specific risk, total return dispersion is driven by both systematic and firm-specific risk.
3

(N), the number of securities in the market (M), and the cross-sectional variance across systematic and firmspecific returns on individual securities (see Appendix A for proof):4 1 2 E XS R p = N

( ( ))

K 1 N 1 2 1 E XS ik k + M 1 k =1 N

N 1 2 1 M 1 E XS ( i ) .

(8)

The fraction of cross-sectional return variance attributed to firm-specific risk is given by the ratio of the last term in Eq. (8) to the total: 2 K 2 % Firm Specific = E XS ( i ) E XS ik k + i . k =1

(9)

Equations (8) and (9) reveal two key benefits of examining return variation across randomly-formed portfolios to evaluate the relation between the number of securities in a portfolio and firm-specific risk. First, given firm-specific shocks account for most of the cross-sectional variation in security returns, firm-specific shocks will also account for most of the cross-sectional variation in portfolio returns, i.e., firm-specific risk plays a much larger role than systematic risk in explaining cross-sectional return variation regardless of the number of securities in the portfolio.5 That is, the key difference between the expected cross-sectional portfolio variance and the expected time-series portfolio variance is that the time-series variance incorporates how securities move together over time (i.e., the second term in Eq. (7) differentiates it from Eq. (8)). Because the week-to-week time-series variation in portfolio returns is primarily driven by systematic factor realizations, even large firm-specific shocks will have a relatively small impact on total time-series volatility, i.e., the difference between total risk for an N-asset portfolio and the market portfolio may be small even though firm-specific risk is large. Second, Eq. (9) illustrates that, unlike time-series variance, the relative role of firmspecific risk in explaining cross-sectional portfolio return variance is independent of portfolio size (i.e., all terms containing N cancel out). In sum, the relative role of firm-specific risk in explaining cross-sectional return variation is both large and constant.

Our proof is a special case of the general proof derived by Elton and Gruber (1977). Firm-specific risk accounts for, on average, approximately 91% of the weekly cross-sectional standard deviation in security returns over the 1966-2004 period based on a five-factor (market, size, value, momentum, and industry) model.
4 5

As noted above, as the number of securities increases, portfolios will have overlapping constituent securities and cross-sectional variation in portfolio returns will fall regardless of firm-specific risk. Nonetheless, given that the last term in Eq. (8) is the expected cross-sectional variance in firm-specific shocks for N-asset portfolios, one can estimate the expected variance of firm-specific shocks for N-asset portfolios (i.e., the last term in Eq. (3)) from the estimated cross-sectional variance of firm-specific shocks in randomly selected N-asset portfolios (see Appendix A for proof). Denoting E( 2 ( P )) as the estimated expected firm2 specific variance for an N-asset portfolio and XS ( p ) as the estimated cross-sectional firm-specific variance

across random N-asset portfolios) yields:

E2 p =

( ( ))

2 XS ( p ) N 1 1 M 1

(10)

In sum, we can generate three estimates of expected firm-specific variance for N-asset portfolios: (1/N) times the average time-series variance of firm-specific returns (i.e., Eq. (5)), (1/N) times the cross-sectional variance of firm-specific returns across individual securities (i.e., Eq. (6)), and the cross-sectional variance in firm-specific returns across randomly-formed portfolios divided by (1-(N-1)/(M-1)), (i.e., Eq. (10)). Empirical tests reported in the next section reveal that all three estimates are essentially identical.

2.3. Cross-sectional variance in time-series variance The expected cross-sectional variance in time-series variances for random N-asset portfolios is given by:
2 2 E XS TS R p

1 ( ( ( ))) = E N
2 TS K k =1

ik k +

K N 1 K 1 2 cov TS ik k , jk k + TS ( i ) N k =1 N k =1

K K N 1 1 2 K 1 2 TS ik k cov TS ik k , jk k TS ( i ) , N N N k =1 k =1 k =1

(11)

10

where the single bars indicate expectations over securities in a given portfolio and the double bars indicate expectations over all securities in the market.6 Eq. (11) demonstrates that the cross-sectional variance in timeseries variance due to differences in firm-specific risk and that due to differences in systematic risk will decline as the number of securities in an equal-weighted portfolio increases. Thus, as pointed out by Elton and Gruber (1977), diversification gains arise from both lower expected risk and greater confidence in that expected value (i.e., a tighter cross-sectional distribution about that expected value).7

3. Empirical results

Most of our empirical tests are based on annual results averaged over the 2000-2004 period. We include each year all ordinary (i.e., Center for Research in Security Prices share code of 10 or 11) New York Stock Exchange, American Stock Exchange, and Nasdaq securities that have at least one hundred weeks of return data over the previous 104 weeks and have complete weekly return data over that year.8 The annual sample sizes range from 4,835 securities in 2000 to 4,177 securities in 2004. Following the literature (e.g., Xu and Malkiel, 2003; Spiegel and Wang, 2005), we estimate the firmspecific portion of a securitys return, each week, as the residual from weekly rolling time-series regressions over the previous two years (i.e., the current and previous 103 weeks) of each securitys excess return on a
Eq. (11) is derived as the expected squared difference between Eq. (7) for a given N-asset portfolio and Eq. (7) for all N-asset portfolios. Eq. (11) represents the expected cross-sectional variance in time-series portfolio variance. The realized cross-sectional variance in time-series variance includes additional terms for the covariance between firm-specific returns for security i and security j, the covariance between firm-specific returns of security i and the systematic returns of security j, and the covariance between the systematic and firm-specific returns of security i. Although each of these covariances has an expected value of zero, they are not restricted to zero in any finite sample. In fact, restricting these covariances to zero violates the independence assumptions of the model. Robustness tests reported in Appendix B, however, reveal that our conclusions are not sensitive to such restrictions (e.g., forcing the average residual to zero by estimating firm-specific shocks through cross-sectional regressions). 7 Elton and Gruber (1977) develop an analytical expression for the expected cross-sectional variance of equal-weighted portfolio time-series variance as a function of the number of securities in a portfolio and the number of securities in the market. Unfortunately, due to computer limitations at the time, the authors were unable to compute the necessary parameters based on all securities in the market. (The authors, however, were able to compute the parameters for a random sample of 150 stocks.) Although current computer capability allows us to compute the Elton and Gruber variance in variance formula for our sample, we do not use their formula because the variance is a sufficient statistic only if the distribution of time-series variances across random portfolios of a given size is normal and our empirical tests reveal this is not the case, especially for smaller portfolios. Instead, we report the average variances for the extreme variance deciles across randomly-selected portfolios. We do find, however, that their formula works well for larger (e.g., greater than one hundred stocks) portfolios. In addition, our primary focus is on cross-sectional variation in firm-specific risk rather than total risk. 8 The survivorship bias we impose by requiring securities to have weekly returns for the entire year suggests our empirical estimates of firm-specific risk are conservative.
6

11

five-factor model that includes the market return in excess of the risk-free rate (denoted Rmt), a size factor (denoted RSMBt), a book-to-market equity factor (denoted RHMLt), a momentum factor (denoted RUMDt), and an industry factor (the value-weighted industry return in excess of the risk-free rate, denoted Rjt where security i is in industry j):9 R it = im R mt + iHML R HMLt + iSMB R SMBt + iUMD RUMDt + ij R jt + it . (12)

We next randomly select, at the beginning of each calendar year, portfolios of size N (N=10 to 4,000 securities) and compute each portfolios annual return and realized variance (based on weekly returns) as well as the systematic and firm-specific components of each.10 Because the cross-sectional variance of realized portfolio volatility and returns declines (and computer requirements increase) as the portfolios grow in size, the number of randomly-selected portfolios we evaluate declines with N. Specifically, we form 5,000 random portfolios for sizes N=10 to N=100, in 10-stock increments (e.g., 5,000 portfolios of size 10, 20, 30, , 100), 2,000 random portfolios for sizes N=200 to 900 by 100 stock increments, and 1,000 random portfolios for sizes N=1,000 to 4,000 by 1,000 stock increments. This procedure is repeated for each year in the sample period, and most of the results presented in this section are based on averages across the five calendar years (2000-2004) under evaluation (we examine diversification over earlier periods in Section 3.4).

3.1. Equal-weighted portfolio return variance We begin by evaluating the relation between the number of securities in a portfolio and the expected time-series variance of portfolio returns. The bold line in Fig. 3A plots the average annual realized equalweighted portfolio time-series variance as a function of portfolio size for portfolios from 10 to 4,000
market, size, value, and momentum factors are generated by compounding the daily values provided by Ken French. The 48 industries are as defined in Fama and French (1993). Securities with SIC codes not used by Fama and French comprise the 49th industry. Following Durnev, Morck, and Yeung (2004), the industry returns are value-weighted and computed excluding security i. 10 As discussed in, footnote 6 realized time-series variances also include realized covariances between firm-specific shocks across securities in the portfolio, realized covariances between the firm-specific shocks of a security and the systematic shocks of other securities, and realized covariances between the firm-specific shocks of a security and its own systematic shocks. Similarly, realized cross-sectional variances include realized cross-sectional covariances between firmspecific and systematic shocks. We define all such covariances as part of firm-specific risk. Similarly, we define the systematic portion of return as the compound weekly systematic return and the remaining portion of the annual return as firm-specific. As noted in Appendix B, however, we find qualitatively identical results when we restrict the crosssectional covariance between systematic and firm-specific shocks to average zero by estimating firm-specific shocks with a cross-sectional regression.
9 Weekly

12

securities, based on weekly rebalancing to equal weights. Fig. 3B through 3D partition Fig. 3A into more informative units of analysis. The bold line reveals the well-documented relation between the number of securities in a portfolio and the average total risk of the portfolio. The first few securities added to the portfolio size greatly reduce the average portfolio variance. As more securities are added, however, the marginal reduction in average variance declines. [Insert Figure 3 about here] There are two problems with interpreting the bold line in Fig. 3 as evidence that investors can easily form well-diversified portfolios: (1) the fact that a randomly-selected 50-stock portfolio is expected to exhibit only 2% (1/N) of the average securitys firm-specific variance does not mean that every 50-stock portfolio does so, and (2) the fact that the average 50-stock portfolio exhibits only marginally greater total return volatility than the market portfolio does not mean the remaining firm-specific risk is negligible. We begin by focusing on the first issue. The realized time-series variance of a specific N-security portfolio may differ from the average variance of N-security portfolios because the portfolio has different systematic exposures (e.g., beta unequal to the average beta), or because the portfolio experiences above- or below-average firm-specific risk (see Eq. (11)). (Although our focus is on firm-specific risk, we evaluate cross-sectional variation in total, systematic, and firm-specific risk to provide a complete picture of the relation between portfolio size and risk.) The solid outside lines in Fig. 3 report the average annual realized variance for the most (top line) and least volatile (bottom line) deciles of our random samples.11 The inside broken lines in Fig. 3 partition the differences between the average realized time-series variances on portfolios contained in these deciles and the average realized time-series variance for all portfolios (i.e., the bold line) into systematic and firm-specific componentsthe distance between the average (bold line) and the broken line represents the portion due to differences in systematic risk, while the distance between the broken line and the outside solid line corresponds to the portion attributed to differences in firm-specific risk.

11 We focus on the average variance of portfolios in the extreme deciles rather than the cross-sectional variance in timeseries variance because the cross-sectional variance does not provide a sufficient description of the distribution of variances for small portfolio sizes, which are highly skewed. The cross-sectional average variances are computed for stocks in the extreme deciles each calendar year and then averaged over the 2000-2004 period.

13

Examination of Fig. 3 demonstrates that realized portfolio variance may differ substantially from its expected (average) value, i.e., the cross-sectional variation in realized time-series variance is relatively large even when the number of securities is large. For example, for 10% of the 100-stock portfolios, the realized time-series variance averages over 33% greater than the time-series variance for the average 100-stock portfolio (the standard deviation averages about 15% greater (i.e., 1.330.5-1)). To formally test for the presence of diversification gains in the form of an increase in variance certainty as portfolio size grows, we estimate Fstatistics associated with the null hypothesis that the cross-sectional variance in time-series total return variances for each portfolio size equals the cross-sectional variance in variance for the next larger size portfolio, e.g., each year we compare the cross-sectional variance in random 10-stock portfolio variances to the cross-sectional variance in random 20-stock portfolio variances. In addition, we run the tests for both total risk and for firm-specific risk. We reject the null of equal cross-sectional variance in total variance at the 5% level or better in 101 of the 105 tests (five years of data and 22 portfolio sizes yield 105 comparisons, (221)*5). Similarly, we reject the null of equal cross-sectional variance in firm-specific variance at the 5% level or better in 100 of the 105 tests.12 Thus, the results demonstrate statistically significant diversification gains in the form of a reduction in variance in variance for portfolios up to 4,000 stocks. This can be seen in Fig. 3 as the difference between the outside bands, as well as the difference between the outside bands and the inside broken lines (cross-sectional variation in firm-specific risk), contracts as portfolio size grows. We next consider the second issuethat elimination of most of the expected firm-specific risk of holding a single security and a relatively small difference between the expected total return uncertainty for an N-asset portfolio and the market portfolio does not mean the remaining firm-specific risk is negligible. The second column in Table 1 reports the fraction of firm-specific variance of holding a single randomly-selected security that is expected to be eliminated for various size portfolios (i.e., 1-(1/N)) and indicates that relatively small portfolios greatly reduce expected firm-specific variance. The third column in Table 1 reports the difference between the expected annual standard deviation of total returns for an N-stock portfolio and the

Because the tests are overwhelmingly significant, we do not report specific results to conserve space. Tests for equality of variances are one-tailed and based on the folded F-statistic.
12

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annual standard deviation of the equal-weighted market return.13 The results in the second and third columns, consistent with Fig. 1, reveal that the expected firm-specific risk declines quickly with the first few securities added to a portfolio and the expected total return standard deviation for relatively small portfolios is only marginally greater than that for the equal-weighted market portfolio. [Insert Table 1 about here] Columns four, five, and six report the three estimates of the annualized firm-specific variance remaining in N-security portfolios: (1/N) times the realized time-series variance of firm-specific returns averaged across all individual securities (i.e., Eq. (5)), (1/N) times the average weekly realized cross-sectional variance of firm-specific returns (i.e., Eq. (6) averaged over time), and the realized cross-sectional variance in firm-specific returns across the random portfolios divided by (1-(N-1)/(M-1)), (i.e., Eq. (10) averaged over time).14 The last three columns in Table 1 report the square root of the respective estimated expected firm-specific variance as an estimate of the expected standard deviation of firm-specific shocks for a portfolio of N securities. There are four important points to take from Table 1. First, the estimate of N-asset portfolios expected firm-specific risk calculated from individual securities time-series variance (column four), the estimate calculated from individual securities cross-sectional variance (column five), and the estimate calculated from the cross-sectional variance of random N-asset portfolio returns divided by (1-(1-N)/(1-M)) (column six) are essentially identical.15 Second, although relatively small portfolios eliminate, on average, most of the firm-specific risk (column 2) and exhibit only marginally greater total return standard deviation than the market portfolio (column 3), the remaining firm-specific risk is not negligible. For example, although the average 50-stock portfolio eliminates 98% of the firm-specific variance of the average security (second
Computed as the difference between the expected total standard deviation for an N-asset portfolio and the total standard deviation of the equal-weighted market portfolio, i.e., [(1/N)E(2(i))+ E(2(RM))] [ E(2(RM))], where E(2(i)) is calculated, each year, as the cross-sectional average of each securitys time-series estimated firm-specific risk and then averaged over the 2000-2004 period. E(2(RM)) is estimated as the time-series average annual variance of equal-weighted market portfolio over 2000-2004. 14 Time-series estimates are computed each year and averaged across securities. Cross-sectional estimates for both individual securities (i.e., Eq. (6)) and random portfolios (i.e., Eq. (10)) are computed each week. We then average the annualized cross-sectional estimates over time each year (to allow direct comparison with the time-series estimates; see Appendix A for additional discussion). All three sets of estimates are then averaged over the five years in the primary sample period (2000-2004). 15 Because firm-specific residuals exhibit slightly positive covariances across securities (e.g., Hammer and Phillips, 1992) the standard deviations for the random portfolios (last column) are slightly greater than the estimated standard deviations assuming independence (previous two columns).
13

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column), and exhibits only 2% greater annual standard deviation than the equal-weighted market portfolio (third column), the expected standard deviation of the remaining firm-specific risk is approximately 9% per year (last three columns). Third, the results in Table 1 reveal that the standard deviation of firm-specific returns are not negligible for even very large portfolios. The standard deviation of annual firm-specific shocks for portfolios of 500 securities, for instance, averages nearly 3%. Fourth, there are large diversification gains beyond 20, 50, 100, or even 500 stocks. Specifically, using the sample of randomly-generated portfolios, we compute both non-parametric and parametric tests of the null hypothesis that there are no diversification gains associated with moving to the next largest portfolio (e.g., the average firm-specific variance of a 10stock portfolio equals the average firm-specific variance of a 20-stock portfolio). Both sets of tests reject the hypothesis in every case at the 5% level or better.16 In fact, to eliminate (approximately) half of the remaining standard deviation of a portfolios firm-specific shocks, an investor must quadruple the number of securities in the portfolio.17 The average 200-stock portfolio, for example, exhibits half the firm-specific standard deviation as the average 50-stock portfolio (approximately 4.4% per year versus 8.8%) and the average 800stock portfolio still contains one-quarter of the firm-specific risk of the average 50-stock portfolio (approximately 2.2% versus 8.8%).

3.2. Firm-specific returns on equal-weighted portfolios As discussed in the introduction, because firm-specific risk is manifested as deviations from systematic returns, one can evaluate the impact of firm-specific risk for various size portfolios by examining the realized return variation across the randomly-selected portfolios. Thus, each calendar year, we compute the annual deviation from the equal-weighted market return for the random portfolios in the top and bottom
Specific results are not reported to conserve space. We compute the cross-sectional variance in firm-specific returns each week (over the five-year period) for the random portfolios of each size. We then inflate the estimates by (1-(1N)/(1-M)) (see Eq. (10) and Appendix A; inflating the estimates works against our ability to reject the null). We then estimate Wilcoxon rank-sum tests of the null hypothesis that the two sets of weekly variances have the same location parameter. In every case, we can reject the null at the 5% level or better. In addition, we compute parametric t-tests for difference in mean variances. Again, for every case we reject the null (at the 5% level or better) that adjacent portfolio sizes have equal mean firm-specific risk. 17 From Eq. (4), the ratio of the expected variances of firm-specific shocks for portfolios of size kN and N is 1/k. The standard deviation of a portfolio of kN securities is thus expected to be 1/k.5 that of a portfolio of N securities. As a result, quadrupling the number of securities (k=4), will cut the portfolios expected standard deviation of firm-specific shocks in half.
16

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performance deciles. Analogous to Fig. 3, the solid lines in Fig. 4A plot these annual deviations (averaged over the five years in the sample period) as a function of portfolio size.18 The broken lines in Fig. 4A partition the differences between the top and bottom deciles average annual returns and the market return into firmspecific and systematic components (e.g., the distance between the top solid line and the top broken line represents firm-specific return).19 As before, Fig. 4B through 4D partition the results into more informative units of analysis. [Insert Figure 4 about here] Consistent with Eq. (9), the relative role of firm-specific risk in explaining cross-sectional return variation is approximately constant across different portfolio sizesfirm-specific shocks (i.e., the difference between the broken lines and the outside lines) account for an average of 86.8% of the total return difference between the top and bottom deciles (i.e., the difference between the outside lines), ranging from a low of 85.2% (for 1,000-stock portfolios) to a high of 87.2% (for 80-stock portfolios). Moreover, given firm-specific risk is negligible when the outside lines are negligibly different from the horizontal axis, the results in Fig. 4, consistent with Table 1, reveal no evidence investors can eliminate firm-specific risk regardless of the number of securities they hold. For example, the average return difference between 50-stock portfolios in the top and bottom deciles is 37% per year and nearly all of this difference (87%) is due to differences in firm-specific shocks. In other words, over the sample period, an investor holding a randomly-selected 50-stock portfolio had a one in five chance of averaging a return that differed from the equal-weighted market return by 18% (i.e., 37%/2) over the next year. The results also confirm that even extremely large portfolios exhibit nonnegligible firm-specific risk (i.e., are not well-diversified)the annual return difference between the top and bottom deciles for 1,000-stock portfolios averages 7.3% and, again, nearly all the difference (85%) is attributed to firm-specific shocks. In fact, as noted in the introduction, because firm-specific risk accounts for a large and constant fraction of cross-sectional return variation, N-assets are sufficient for a well-diversified
We focus on the extreme deciles rather than the cross-sectional standard deviation because standard deviation is a sufficient description only if the cross-sectional return distribution is normal. In addition, we focus on the average return within each decile, rather than the decile breakpoint, because although the relative role of expected firm-specific risk is constant (Eq. (9)), the relative role of firm-specific risk for a given portfolio is not contant, e.g., the firm-specific risk in the one portfolio that serves as the decile breakpoint for each portfolio size, is not contant. 19 Although Fig. 3 and 4 are generated from the same set of random portfolios, the portfolios that form the top and bottom return deciles in Fig. 4 are not necessarily the same that form the top and bottom variance deciles in Fig. 3.
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portfolio only when the return variation across random N-asset portfolios is negligible. The results in Fig. 4 clearly indicate non-negligible cross-sectional variation in portfolio returns regardless of portfolio size. Fig. 4 also indicates substantial diversification gains beyond 20, 50, 100, or even 500 securities, i.e., there are gains to diversification as long as the differences between the outside lines and the inside broken lines in Fig. 4 contract. As a formal test of whether these diversification gains are statistically significant, each week we test the null hypothesis that the cross-sectional total return and firm-specific return variances for portfolios of each size are equal to the corresponding cross-sectional variance for the next largest portfolio size. Of the 5,481 test statistics (261 weeks times 21 comparisons each week), we reject the hypothesis (at the 5% level or better) that adjacent portfolio sizes exhibit equal cross-sectional total or firm-specific variance in more than 97% of the cases.20 In short, the results in Fig. 4 demonstrate that: (1) there is no evidence investors can form portfolios with negligible firm-specific risk, and (2) there are substantial and statistically significant diversification gains possible beyond 20, 50, 100, or even 500 stocks.

3.3. Value-weighted portfolios Although it is most common to consider the role of firm-specific risk in equal-weighted portfolios, investors, in aggregate, hold a value-weighted portfolio. In addition, recent evidence shows that both individual and professional investors hold portfolios that deviate substantially from equal weights (e.g., Goetzmann and Kumar, 2004; Cohen, Gompers, and Vuolteenaho, 2002). In this section, we examine the relation between firm-specific risk and portfolio size for value-weighted portfolios that potentially provides a better view of diversification in practice. Specifically, we repeat the cross-sectional variation in returns analysis with three changeswe value-weight the portfolios, we set the probability of inclusion proportional to capitalization ranking when forming random portfolios, and we only evaluate portfolio sizes up to 1,000 securities.21 We do not claim that these portfolios necessarily reflect investors actual portfolios any better

Test statistics are not reported to conserve space. The tests are based on a one-tail test of the Folded-F statistic. The probability of inclusion is set proportional to capitalization ranking, e.g., if there are 4,500 stocks in the sample, the largest stock is 4,500 times more likely to be selected than the smallest stock. Note that, due to the extreme skewness in capitalization, we cannot form larger portfolios (i.e., beyond a few stocks) if we set the probability of inclusion proportional to market capitalization. Although specific results are not reported to conserve space, we find (not
20 21

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than randomly-chosen equal-weighted portfolios. Rather, given evidence that investors typically do not hold equal-weighted portfolios, our focus is on understanding how value weighting impacts firm-specific risk. Fig. 5A (portfolio sizes of 10 to 100 stocks) and 5B (portfolio sizes of 100 to 1,000 stocks) report the average annual deviation from the value-weighted market portfolio return for the top and bottom deciles of the value-weighted portfolios as a function of portfolio size. The results in Fig. 5 demonstrate that an investor holding a value-weighted portfolio also faces very large firm-specific risk, i.e., the outside lines are far apart and primarily driven by firm-specific shocks. For example, the average difference in returns for 100-stock portfolios in the top and bottom deciles is 34% per year (63% of the difference is due to differences in firmspecific shocks). Even 1,000-stock portfolios exhibit a tremendous amount of firm-specific riskthe difference in returns between the top and bottom deciles of random 1,000-stock portfolios averages 9.7% with 62% of the difference attributed to firm-specific shocks. The results also reveal continual and nonnegligible gains to diversification as the difference between the outside lines and the adjacent broken lines continues to shrink (and the outside lines contract toward the horizontal axis) as portfolio size grows. As a formal test that these gains are statistically meaningful, we test the null that there are no diversification gains in moving to the next largest value-weighted portfolio by comparing the cross-sectional firm-specific variance for adjacent portfolio sizes. Similar to the results for the equal-weighted portfolios, we reject the null hypothesis in over 96% of the 4,698 comparisons.22 [Insert Figure 5 about here]

3.4. Firm-specific risk over time Our results, focusing on a period of high firm-specific risk relative to historical averages, may not hold over other periodsalthough an investor holding a 20-stock portfolio over the 2000-2004 period bore very large levels of firm-specific risk, it is possible that 20-stock portfolios were well-diversified in earlier periods. Fig. 6 reports the year-by-year average return difference (over 1966-2004) between portfolios in the
surprisingly) even greater evidence of investors inability to eliminate firm-specific risk in value-weighted portfolio when selection is truly random (i.e., not proportional to capitalization ranking). 22 Specific results are not reported to conserve space. The 4,698 tests are generated from 18 comparisons each week across 261 weeks.

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top return decile and portfolios in the bottom return decile for random portfolios of 20, 50, 100, and 500 stocks.23 [Insert Figure 6 about here] The results demonstrate that 20-stock portfolios have never been well-diversified. The smallest difference between the top and bottom deciles of 20-stock portfolios was 21% and the return difference over the entire sample period (1966-2004) averages 46% per year. In addition, although firm-specific risk has been higher, on average, in more recent years, a number of early years exhibit very large firm-specific shocks. In 1967, for example, the average return difference between the top and bottom deciles of random 20-stock portfolios was 69%. We find no evidence that even large portfolios had negligible firm-specific riskthe return difference for the top and bottom deciles of 500-stock portfolios, for instance, averages 8.6% per year over the 1966-2004 period. The results also reveal that investors would have reaped substantial diversification gains by holding larger portfolios than those traditionally recommended (e.g., return differences for 100-stock portfolios are substantially and statistically lower than for 20-stock portfolios).24 In 1967, for example, the difference in annual returns for the extreme deciles was 69% for 20-stock portfolios versus 31% for 100stock portfolios. Moreover, although not reported in the figure, nearly all the difference in these portfolio returns arises from firm-specific riskon average, over the entire 1966-2004 period, firm-specific shocks account for 84% of the difference. In sum, Fig. 6 reveals: (1) there is no evidence that investors have ever been able to form portfolios with negligible firm-specific risk, and (2) there have always been large diversification gains possible beyond 20 stocks.

3.5. Is the market portfolio well-diversified? It is straightforward to estimate the expected firm-specific risk of the equal-weighted market portfolio as the square root of the expected firm-specific variance for a single randomly-selected security divided by the number of securities in the market (i.e., the square root of Eq. (4) when N is set to the number
23 Consistent with previous work (Campbell, Lettau, Malkiel, and Xu, 2001), the results suggest that firm-specific risk has generally increased over time. 24 Both parametric and non-parametric tests of the null hypothesis that the difference between each line and the line above is zero are rejected in every case at the 1% level. Details are available upon request.

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of securities in the market).25 Doing so reveals no evidence that the firm-specific risk contained in the equalweighted market portfolio is negligible over the 1966-2004 period. Specifically, the estimated annual firmspecific standard deviation of the equal-weighted market portfolio averages 0.84% (ranging from 0.61% to 1.07%).26 Assuming the expected annual market risk premium is 6%, then approximately once every three years the firm-specific shock for the equal-weighted market portfolio will exceed 15% of the expected risk premium. Because U.S. markets are highly concentrated and the expected firm-specific variance for the valueweighted market portfolio is given by the sum of products of individual securities squared market weights and firm-specific variances, the value-weighted market portfolio is likely to suffer from even greater firmspecific risk than the equal-weighted market portfolio. For example, over the 2000-2004 period, the ten largest stocks in our sample accounted for, on average, over 20% of the total market capitalization. Thus, the firm-specific return on the value-weighted market portfolio is the sum of 20% of the firm-specific return for the top 10 stocks and 80% of the firm-specific return for the remaining 4,000+ stocks. Assuming the portfolio of the 10 largest stocks is not well-diversified, the value-weighted market portfolio is not welldiversified. Consider, for example, that in 2004, excluding just two securities with large negative firm-specific shocks (Pfizer with a -23.58% return and Intel with a -28.69% return) increases the value-weighted market return by 140 basis points from 12.71% to 14.11%.

3.6. Robustness tests The outside lines in Fig. 3 through 5 are not model-dependentthese are simply the average annual ex-post top and bottom decile realized portfolio variances or returns. The decomposition of returns
If the market portfolio is used as a factor, the estimated firm-specific risk of the market portfolio will be zero. Because we use the Fama and French model that incorporates the value-weighted market portfolio, the estimated firmspecific risk for the equal-weighted market portfolio need not be zero. In general, there is nothing to require the actual firm-specific return for either the value- or equal-weighted market portfolio to be zero. Consider a simple exampleif there are only two securities in the market and 90% of their returns arise from firm-specific shocks, the market portfolio will not be well-diversified. In addition, techniques that force the estimated firm-specific shocks for the market to zero violate the assumptions of the model. For example, in a two asset case with a market factor, the residuals of the two assets will exhibit perfect negative correlation (rather than independence). 26 Computed as the time-series estimate of firm-specific variance for each security each year divided by the number of securities at that point in time (Eq. (5)). We find similar results using the cross-sectional estimate of firm-specific risk (Eq. (6)).
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into firm-specific and systematic components, however, is model-dependentthe true underlying return generating process is unobservable and, even if the correct model were used to decompose returns, factor sensitivities (a required input) are estimated with error. Our analysis demonstrates, however, that most crosssectional variation in portfolio returns will arise from firm-specific shocks as long as most of the cross-sectional variation in individual security returns arises from firm-specific shocks (Eq. (9)). Thus, although our estimate of the firm-specific portion of return is model- and method-dependent, our conclusions will remain unchanged as long as firm-specific risk accounts for a majority of the cross-sectional variation in security returns. Nonetheless, in Appendix B, we consider a number of robustness tests including: (1) two additional factor models (market plus industry model, three-factor plus industry model), (2) the exclusion of the industry factor, and (3) cross-sectional rather than time-series estimates of firm-specific risk. As discussed in detail in Appendix B, the results remain qualitatively identical. To ensure our results are not driven by small stocks (that have higher firm-specific risk), we repeat the analysis, limiting the sample of securities to those in the top half of market capitalization. Results, discussed in greater detail in Appendix B, reveal about a one-third reduction in return variation across random portfolios. Thus, although large stocks have less firm-specific risk than small stocks, the results reveal no evidence that investors can form well-diversified portfolios by restricting their investment universe to large capitalization securities. Another potential concern is that levels of diversification associated with randomly chosen portfolios might be substantially different than for carefully chosen portfolios. As Malkiel (1999) notes, for example, the golden number for American xenophobesthose fearful of looking beyond our national bordersis about twenty equal-sized and well-diversified U.S. stocks (clearly twenty oil stocks or twenty electrical utilities would not produce an equivalent amount of risk reduction) Recognize, however, that by definition, firmspecific shocks are expected to be independent across securities. Thus, the argument that securities should be carefully chosen to ensure a well-diversified portfolio is (implicitly or explicitly) actually concerned with diversifying industry effects (e.g., your portfolio should not have 20 oil stocks) or systematic effects (e.g., your portfolio should have both large and small capitalization stocks), rather than firm-specific risk. That is, ex

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ante, one cannot carefully select securities that will have offsetting firm-specific shocks unless one expects such shocks to be non-independent (in which case they are not firm-specific). Given our analysis yields estimates of firm-specific risk accounting for industry and systematic (market, size, value, and momentum) returns, the estimated firm-specific shock of any random portfolio focuses only on the portion of each stocks return that is independent of industry and systematic effects. Nonetheless, Appendix B also considers an alternative method that carefully chooses portfolios to ensure industry diversification. Not surprisingly, our results remain qualitatively identical.

4. Conclusions

Because the return standard deviation of relatively small portfolios averages only marginally larger than that for the equal-weighted market portfolio, conventional wisdom (and nearly every finance textbook) holds that investors can form well-diversified portfolios by owning a relatively small number of securities typical estimates range between eight and 30 stocks, although more recent estimates suggest 50 stocks are needed. Our results, contrary to conventional wisdom, demonstrate that this fact does not imply firm-specific risk is negligible or that there are no gains to further diversification. So how many securities does an investor need to ensure their firm-specific return will be negligibly different from zero? The answer depends on a working definition negligibly. As a result of the pervasive belief investors can easily form portfolios that have essentially no firm-specific risk (see introduction), previous work does not provide such a definition. Assuming an expected market risk premium of 6%, we propose that a reasonable definition of an approximately well-diversified portfolio is one that has a 95% chance of a firm-specific return less than 1% (i.e., a 5% chance that the absolute firm-specific shock will be greater than 16.7% of the risk premium). In fact, this definition may be overly generous as, in practice, it is unlikely one would argue beating a benchmark portfolio by 100 basis points suggests the managers contribution was negligibly different from zero. Given this definition (or one of the readers choosing), it is straightforward to estimate the number of securities required for a well-diversified portfolio. Specifically, solving Eq. (4) for N, using 0.5% for the portfolio standard deviation (i.e., two standard deviations equals

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1%), and our empirical estimate of the expected annual firm-specific variance for a single stock over the 2000-2004 period (39.12%), reveals that an approximately well-diversified portfolio would require 15,647 stocks (i.e., 0.3912/0.0052)! Last, consider how estimation error or missing factors might impact this conclusion. The annual variance of the average security in our sample is 48.84% consisting of systematic variance of 9.72% and firmspecific variance of 39.12%. If we make the (generous) assumption that estimation error and omitted factors account for as much variation as the specified factors (market, size, value, momentum, and industry), then the average securitys firm-specific variance estimate is 29.4% (i.e., 0.4884-(2*0.0972)). In this case the number of securities required for a well-diversified portfolio is 11,760 (i.e., 0.294/0.0052). In short, it is highly unlikely that different estimation techniques would lead to the conclusion that 20, 200, or even 2,000 stocks has ever been sufficient to form a well-diversified portfolio. Our results have a number of implications for asset pricing, market efficiency, and portfolio management theories. First, investors inability to easily eliminate firm-specific risk means that asset pricing theories may hold only approximately. This may help explain the persistence of some anomalies and the possibility of bubbles in assets prices. Second, investors inability to easily eliminate firm-specific risk suggests that firm-specific risk may be a priced factor. Third, despite holding portfolios with only slightly greater total risk than the market portfolio, professional managers are not necessarily closet indexers. Although a number of studies (e.g., Goetzmann and Kumar, 2004) suggest individual investors face substantial firmspecific risk, our results also suggest that professional investors, who hold much larger portfolios, also face substantial firm-specific risk. Last, arguments that few securities are needed to eliminate firm-specific risk are misguided. Even very large portfolios contain substantial firm-specific riskone in five random 500-stock portfolios averaged an annual firm-specific shock of 5% in recent years (2000-2004). Moreover, our results are not period-specificthere is no evidence that a small portfolio has ever been well-diversified. In fact, we find no evidence an investor can, or has ever been able to, form a well-diversified portfolio regardless of the number of securities held.

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References

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Table 1 Firm-specific risk and portfolio size (2000-2004)

This table reports the expected firm-specific risk faced by an investor holding an equal-weighted portfolio of N securities. The second column reports the expected fraction the firm-specific variance of holding a single security eliminated by holding N securities (i.e., 1-1/N). The third column reports the expected difference between the standard deviation of the average N-asset annual portfolio return and the standard deviation of the equal-weighted market portfolio. The fourth, fifth, and sixth columns report three estimates of firm-specific variance for N-asset portfolios: (1/N) times the average time-series estimate of firm-specific variance for a single security, (1/N) times the cross-sectional estimate of firm-specific variance for a single security, and the cross-sectional variance of firm-specific returns of randomly-selected N-asset portfolios divided by (1-(1-N)/(1-M)), where M is the number of securities in the market. The last three columns report the square root of columns four through six as estimates of the expected standard deviation of firm-specific shocks for N-asset portfolios.
Number of securities in portfolio Expected fraction of a single stocks firm-specific variance eliminated 90.00% 95.00% 96.67% 97.50% 98.00% 98.33% 98.57% 98.75% 98.89% 99.00% 99.50% 99.67% 99.75% 99.80% 99.83% 99.86% 99.88% 99.89% 99.90% 99.95% 99.97% 99.98% Total standard deviation of portfolio standard deviation of EW market 8.45% 4.61% 3.18% 2.43% 1.97% 1.65% 1.42% 1.25% 1.12% 1.01% 0.51% 0.34% 0.26% 0.21% 0.17% 0.15% 0.13% 0.11% 0.10% 0.05% 0.03% 0.03% Expected variance of firm-specific shocks Average timeAverage Cross-sectional series firmcross2 of firm2 sectional specific specific returns firm-specific divided by N in random 2 divided by portfolios/ (1-(N-1)/(M-1)) N 3.91% 3.90% 4.09% 1.96% 1.95% 2.03% 1.30% 1.30% 1.34% 0.98% 0.98% 1.00% 0.78% 0.78% 0.80% 0.65% 0.65% 0.67% 0.56% 0.56% 0.57% 0.49% 0.49% 0.51% 0.43% 0.43% 0.44% 0.39% 0.39% 0.41% 0.20% 0.20% 0.20% 0.13% 0.13% 0.13% 0.10% 0.10% 0.10% 0.08% 0.08% 0.08% 0.07% 0.07% 0.07% 0.06% 0.06% 0.06% 0.05% 0.05% 0.05% 0.04% 0.04% 0.04% 0.04% 0.04% 0.04% 0.02% 0.02% 0.02% 0.01% 0.01% 0.01% 0.01% 0.01% 0.01% Expected standard deviation of firm-specific shocks Cross-sectional Cross-sectional Time-series of firm-specific of firm of firmshocks specific shocks specific returns in random portfolios 19.78% 13.99% 11.42% 9.89% 8.84% 8.07% 7.48% 6.99% 6.59% 6.25% 4.42% 3.61% 3.13% 2.80% 2.55% 2.36% 2.21% 2.08% 1.98% 1.40% 1.14% 0.99% 19.75% 13.97% 11.40% 9.87% 8.83% 8.06% 7.46% 6.98% 6.58% 6.25% 4.42% 3.61% 3.12% 2.79% 2.55% 2.36% 2.21% 2.08% 1.97% 1.40% 1.14% 0.99% 20.22% 14.26% 11.59% 10.02% 8.93% 8.16% 7.53% 7.16% 6.64% 6.37% 4.47% 3.67% 3.16% 2.82% 2.59% 2.38% 2.24% 2.11% 1.98% 1.44% 1.15% 1.00%

10 20 30 40 50 60 70 80 90 100 200 300 400 500 600 700 800 900 1,000 2,000 3,000 4,000

Appendix A: Proofs A.1. Proof of equations (5) and (6) Eq. (4) expresses the expected firm-specific variance for a randomly-selected equal-weighted N-asset portfolio as (1/N) times the expected firm-specific variance for a single security. Therefore, to examine the relation between expected firm-specific risk and the number of securities in a portfolio, one needs an estimate of the expected variance of a single randomly-selected securityalthough each security has its own individual underlying distribution of firm-specific shocks, the goal is to estimate the expected variance of a randomlyselected security. Given each stock is equally likely to be selected for inclusion, this requires estimating a distribution of firm-specific shocks that arises from a mixture of distributions, i.e., the distribution of firmspecific shocks pooled over all securities. To see this, assume (for ease of notation) that each stocks firmspecific distribution is discrete and can be described by D possible draws. In addition, assume that a given outcome can occur multiple times (e.g., a stock may have 1,000 possible draws of a firm-specific shock of zero and only one possible draw of a -70 percent firm-specific shock). In this framework, each stocks distribution can take any form (i.e., may be normal or non-normal). Given that the expected firm-specific shock for any security is zero, the firm-specific variance for a given stock i is:

2 ( i ) =

1 D

d =1

2 id

(A1)

The expected variance for a randomly-selected security is computed as the average variance across all M securities in the market:
E 2 ( i ) = 2 ( i ) =

1 M

2 ( i ) =
i =1

1 M

i =1

1 D

id2 =
d =1

1 1 M D

i =1 d =1

2 id .

(A2)

As the last term demonstrates, Eq. (A2) is simply the variance of the distribution of firm-specific shocks pooled over all securities. There are two approaches to estimating this underlying pooled distribution: (1) sample firm-specific shocks for each security over time to compute an estimate of each securitys firm-specific variance and then average these variance estimates across securities, or (2) sample firm-specific shocks across securities at a

point in time. Traditionally, researchers have taken the former approach to estimating the expected variance of the pooled distribution of firm-specific shocks. Specifically, the time-series estimate of the expected firm specific variance for a given security (i=1) is computed as (where E indicates estimated expected value): 2 E 2 ( i =1 ) = TS ( i =1 ) =

2 1 T i =1, t i =1 . T 1 t =1

(A3)

The estimated expected variance for any randomly-selected security (i.e., the expected variance of the pooled distribution) is Eq. (A3) averaged across all M securities (Eq. (5)): 1 2 E 2 ( i ) = TS ( i ) = M

2 TS ( i ) = i =1

1 M

2 1 T it i . i =1 T 1 t =1

(A4)

Alternatively, the sample of firm-specific shocks at a point in time can be used to estimate the underlying pooled distribution. That is, given a sample of approximately 4,500 securities, one has 4,500 sample points of firm-specific shocks from the pooled distribution (at each point in time) that can be used to estimate the variance of the underlying pooled distribution. Specifically, the expected firm-specific variance of the pooled distribution (i.e., the expected firm-specific variance of holding a single randomly-selected security) at a point in time (t=1) is estimated as the cross-sectional (denoted XS) variance in firm-specific shocks at time t (Eq. (6)):1 2 E 2 ( i ) = XS ( i ) =

1 M 1

(
M i =1

i ,t =1

t =1 .

(A5)

Both Eqs. (A4) and (A5) are estimates of the expected firm-specific risk of holding a single randomly-selected security.

de Silva, Sapra, and Thorley (2001) note that in sampling residuals across securities one must assume the distribution of firm-specific residuals is: (a) normal, and (b) the same for every security, to ensure that the cross-sectional distribution of residuals is normal (and therefore adequately described by variance). As noted above, because each security is equally likely to be selected in a random draw, the underlying pooled distribution results from a mixture of distributions (if one makes the reasonable assumption that the distribution of firm-specific risk may differ across securities) and therefore, may not be normally distributed. Thus, de Silva, Sapra, and Thorleys point applies to the underlying distribution (i.e., the true pooled distribution of firm-specific shocks may not be normally distributed), not the method used to estimate that distributionboth the cross-sectional estimate and the traditional time-series estimate suffer from the same limitation (i.e., variance may not fully describe the distribution). Hence, the cross-sectional variance and the average time-series variance estimates are essentially, identical (both theoretically (Eqs. (A4) and (A6)) and empirically (Table 1)). As noted in the paper, because the pooled distribution may be non-normal (especially for smaller portfolios), we primarily focus on reporting averages for the extreme deciles (rather than variances).
1

Averaging Eq. (A5) over time does not change its expected value:2 1 2 E 2 ( i ) = XS ( i ) = T

M 1 (
T

i ,t

).
2

(A6)

t =1

i =1

Examination of Eqs. (A4) and (A6) reveal that the cross-sectional average estimated time-series variance (Eq. (A4)) is nearly identical to the cross-sectional variance estimate averaged over time (Eq. (A6)). Although both are unbiased estimates of the expected firm-specific variance of holding a single randomly-selected security, the empirical estimates will differ slightly because they are generated from two different samples. Specifically, although the expected firm-specific shock is zero (both for every individual security and across all securities at a point in time), the average firm-specific shock across securities and over time will differ (e.g., i will differ across securities and from t ). In addition, unless the number of periods and number of securities in the market are equal, the denominators will differ slightly, i.e., T*(M-1) M*(T-1).3

A.2. Proof of equation (7) The expected time-series variance (denoted with TS subscript) of an equal-weighted portfolio can be written as (see Markowitz, 1959):
( N 1) 1 2 2 E TS R p = E TS (R i ) + E cov TS R i , R j . N N Substituting Eq. (1) into Eq. (A7) yields:
K K K N 1 1 2 2 E TS R p = E TS ik k + i + E cov TS ik k + i , jk k + j . N N k =1 k =1 k =1

( ( ))

))

(A7)

( ( ))

(A8)

Because the expected covariance between a given securitys systematic and firm-specific components is zero, the first term on the right-hand side of Eq. (A8) can be partitioned into (1/N) times the expected systematic variance and (1/N) times the expected firm-specific variance. Similarly, because firm-specific components are
This assumes the distribution of firm-specific shocks is stationary over period it is averaged. Note that the traditional time-series estimate of firm-specific risk (Eq. (A3)) also assumes the distribution is stationary over the estimation period. If the distribution changes over time, then Eq. (A5) remains valid, but the traditional method of averaging time-series variances across securities (i.e., Eqs. (A3) and (A4)) is not valid. See Solnik and Roulet (2000) for further discussion. 3 Because both the number of periods (T) and the number of securities (M) is large in our sample, the difference between T*(M-1) and M*(T-1) is small.
2

independent across securities, the expected covariance is simply the expected covariance between the systematic components:
K K N 1 K 1 1 2 2 2 E TS R p = E TS ik k + E cov TS ik k , jk k + E TS ( i ) . (A9) N N N k =1 k =1 k =1

( ( ))

A.3. Proof of equations (8) and (10) Elton and Gruber (1977) prove (see their Appendix A) that if the variable Xi is selected N times from M securities, then: 1 E N

2 1 N 1 2 X i = 1 XS (X i ) + X i . N M 1 i =1
N

( )

(A10)

Define X i = R i R p where R p as the cross-sectional average return across all N-asset portfolios. Because the average return across all possible N-asset portfolios is equivalent to the average return across all securities
2 (i.e., R p = Ri ), X = Ri R p = Ri Ri = 0 and (X ) = Ri Ri = 0. Thus, 2

1 2 E XS R p = E N

( ( ))

(R
N i =1

1 N 1 2 R p = 1 E XS (R i ) . N M 1

(A11)

In addition, given the assumption that factor premia realizations are independent of firm-specific shocks (see Section 2), the expected cross-sectional variance in firm-specific returns across individual securities is given by:
2 K 2 K 2 2 E XS (R i ) = E XS ik k + i = E XS ik k + E XS ( i ) . k =1 k =1

(A12)

Substituting Eq. (A12) into the right-hand side of Eq. (A11) yields Eq. (8):4
1 2 E XS R p = N

( ( ))

K 1 N 1 2 1 E XS ik k + M 1 N k =1

N 1 2 1 M 1 E XS ( i ) .

(A13)

Focusing on just the firm-specific portion of Eq. (A13):

4

As the number of securities in the market (M) approaches infinity, Eq. (8) is analogous to de Silva, Sapra, and Thorleys Eq. (4).

N 1 1 2 2 E XS p = 1 E XS ( i ) . M 1 N

( ( ))

(A14)

Given: (1) the expected firm-specific variance for an N-asset portfolio equals (1/N) times the expected firmspecific variance of holding a single randomly-selected security (Eq. (4)), and (2) that the expected value of the cross-sectional variance of firm-specific shocks across all individual securities is the expected firm-specific variance of holding a single randomly-selected security (see Appendix A.1), we can substitute the expected variance for an N-asset portfolio (i.e., E( 2 ( p ))) for the last term in Eq. (A14):

N 1 2 2 E XS p = 1 E p . M 1

( ( ))

( ( ))

(A15)

2 Substituting in the estimated cross-sectional variance in portfolio returns ( XS ( p )) for the left-hand side of Eq. (A15) and rearranging yields Eq. (10):

E2 p =

( ( ))

2 XS ( p ) N 1 1 M 1

(A16)

Appendix B: Robustness tests

Estimates of firm-specific risk in the figures and Table 1 are based on a five-factor model: the threefactor Fama and French (1993) model (market, size, value factors), a momentum factor, and an industry factor. We estimated five additional variations of this model: (1) a single factor market model (2) the Fama and French (1993) three-factor model, (3) the Fama and French three-factor model plus a momentum factor (the four-factor model), (4) the market model that includes an industry factor, and (5) the Fama and French three-factor model that includes an industry factor. The first row in Panel A of Table B1 reports the difference between the average returns for portfolios in the top decile and portfolios in the bottom deciles, for random equal-weighted portfolios of 10, 50, 100, 500, and 1,000 stocks (i.e., the vertical difference between the outside lines in Fig. 4). The next six rows in Panel A report the portion of the difference attributed to firm-specific factors based on the market model, three-factor model, four-factor model, market model including industry returns, three-factor model including industry returns, and the four-factor model including industry returns (i.e., the model used in the paper), respectively. Panel B repeats the analysis for value-weighted portfolios. The results demonstrate that regardless of the model or adjusting for industry returns, a minimum of 85 percent of the difference in equalweighted portfolio returns arises from firm-specific factors. Similarly, a minimum of 62 percent of the difference in value-weighted portfolio returns arises from firm-specific factors. [Insert Table B1 about here] In the preceding analysis, we estimate firm-specific risk as the weekly residual from a regression based on the current and lag 103 weeks of data (Eq. (12)). Because the weekly residuals are computed with regressions that are updated weekly, the estimated realized firm-specific shocks for any individual security are not required to sum to zero over the year of evaluation. Moreover, there is no restriction that the equalweighted market portfolio must estimated firm-specific risk of zero. As an alternative approach, we follow Ferson and Harvey (1991) and estimate firm-specific risk as the residual in weekly cross-sectional regressions

of returns on estimated factor sensitivities.5 This approach constrains the weekly estimated firm-specific return for the equal-weighted market portfolio to be zero. Specifically, following Ferson and Harvey, we first
estimate factor sensitivities (i.e., ) in time-series regressions of individual security returns on the factor portfolios. Next, each week, we estimate the following cross-sectional regression: R it = 0t + mt imt + HMLt iHMLt + SMBt iSMBt + UMDt iUMDt + it , (B1)

where the residual serves as the estimated portion of security is return in week t that is due to firm-specific factors and the remaining terms comprise the estimated systematic return. Similarly, we generate cross-sectional estimates of firm-specific shocks that account for industry effects by adding industry dummy variables [for each of the 49 Fama and French (1997) industries] to the weekly cross-sectional regressions given in Eq. (B1): R it =

j =1

49

jt

+ mt imt + HMLt iHMLt + SMBt iSMBt + UMDt iUMDt + it .

(B2)

The residual from Eq. (B2) serves as our cross-sectional estimate of firm-specific return that accounts for industry effects. We also repeat the analysis with the market model and the three-factor model. The first row in Panel A of Table B2 reports the average return difference for the top and bottom deciles of random equal-weighted portfolios for portfolios of 10, 50, 100, 500, and 1,000 stocks (i.e., the difference in the outside lines in Fig. 4). The next six rows in Panel A report the portion of the return difference attributed to firm-specific factors based on the cross-sectional estimates of each of the six models (market model, three-factor model, four-factor model, market model with industry effects, three-factor model with industry effects, and the four-factor model with industry effects). Panel B reports analogous figures for value-weighted portfolios. [Insert Table B2 about here] Consistent with the results in Table B1, the results in Table B2 reveal that firm-specific returns primarily drive cross-sectional variation in returns for portfolios of any size. For example, across all six
5

These cross-sectional estimates of firm-specific risk technically violate the assumptions of the model because the restriction that the firm-specific shocks sum to zero each week implies firm-specific shocks are not independent, e.g., the value of any specific residual is the negative of the sum of the remaining residuals.

models and portfolio sizes, firm-specific risk accounts for a minimum of 79 percent of the cross-sectional variation in equal-weighted portfolio returns. Because we include all securities in our selection pool, it is possible that smaller stocks (that typically have higher firm-specific risk than larger stocks) play a large role in driving our inability to form welldiversified portfolios. Although we are not aware of any arguments that suggest small stocks should be excluded from a well-diversified portfolio, we nonetheless examine this possibility, by repeating the analysis limiting the sample to the largest one-half of securities each year. The results are summarized in Fig. B1. Specifically, the dashed inside lines in Fig. B1 report the average annual deviations from the equal-weighted market portfolio for the top and bottom return deciles based on randomly-selected portfolios (of 10 to 100 securities) of large capitalization stocks (capitalization greater than median capitalization). For comparison, the solid outside lines report the annual deviations based on randomly-selected portfolios of all securities (i.e., these lines are identical to the solid outside lines in Fig. 4B). [Insert Figure B1 about here] The results in Fig. B1 show, consistent with previous work (e.g., Campbell, Lettau, Malkiel, and Xu, 2001), that small stocks average greater firm-specific risk than large stocks. The results in Fig. B1 also demonstrate, however, that elimination of small stocks from the sample does not yield well-diversified portfolios. The annual return difference between the average returns for the top and bottom deciles of random portfolios of 50 large stocks averages nearly 25 percent. Moreover, although not shown in the graph (to reduce clutter), 78 percent of the return difference is due to firm-specific shocks. Thus, one in five portfolios of 50 large stocks averages a firm-specific return of nearly 10 percent (i.e., 0.25/2*0.78). Moreover, these portfolios have no exposure to the size factor (i.e., Fama and French, 1993, define the size factor by partitioning all securities into above- and below-median capitalization groups). Another potential concern is that we randomly (or carelessly) select securities for each portfolio rather than carefully selecting securities from each industry because, as Malkiel (1999) points out, twenty oil stocks or twenty electric utilities would not produce an equivalent amount of risk reduction Recognize, however, that twenty oil stocks do not produce an equivalent amount of risk reduction as a result of industry

risk rather than firm-specific risk. Because our estimates of firm-specific risk account for industry returns (and other systematic factors), spanning industries should not materially impact our results. Nonetheless, as a robustness test, we also considered the firm-specific risk for carefully-constructed portfolios. Specifically, we carefully construct industry-diversified portfolios by selecting a single random firm from each of the 49 industries and defined the firm-specific return as the residual from a four-factor model (market, size, value, and momentum factors). Next, for comparison, we also formed carelessly constructed portfolios by selecting 49 stocks randomly and evaluated industry-adjusted firm-specific returns (as in the paper). We repeat the exercise 5,000 times to generate two distributions of firm-specific shocks for 49-stock portfolios. The absolute value of the average firm-specific shock in the extreme deciles for the 49 stock carelessly constructed portfolios is 16.13 percent. The absolute value of the average firm-specific shock in the extreme deciles for carefully constructed 49-stock portfolios (i.e., one stock from each industry) is 15.24 percent. Thus, carefully constructing 49-stock portfolios does not create well-diversified portfolios. In addition, the slightly lower estimate of firm-specific risk is driven from the fact that some industries have very few small capitalization securities and therefore the carefully constructed portfolios are biased toward large capitalization stocks.

Table B1 Sensitivity of results to different models (time-series estimates of firm-specific risk) The first row in Panel A reports the average annual return difference for randomly-selected portfolios in the top and bottom return deciles. Results are computed each year between 2000 and 2004 and averaged over the five years. The next six rows report the estimated fraction of the return difference attributed to time-series estimates of firm-specific risk based on a market model, a three-factor model (market, size, and value/growth factors), a four-factor model (market, size, value/growth, and momentum factors), a market model that includes a value-weighted industry return, a three-factor model that includes an industry return, and a four-factor model that includes an industry return (i.e., the model used in the study). Panel B reports analogous figures for value-weighted portfolios. Number of securities in portfolio 10 50 100 500 1,000 Panel A: Equal-weighted portfolios Annual return difference 82.80% 36.55% 26.10% 10.96% 7.26% Market model Three-factor model Four-factor model Market model + industry factor Three-factor model + industry factor Four-factor model + industry factor Annual return difference Market model Three-factor model Four-factor model Market model + industry factor Three-factor model + industry factor Four-factor model + industry factor 96.54% 90.89% 88.89% 93.87% 89.06% 86.72% 74.66% 86.90% 72.62% 72.98% 75.61% 67.50% 66.06% 96.32% 90.76% 88.88% 93.62% 88.93% 86.65% 44.66% 86.34% 70.43% 72.07% 71.54% 62.20% 61.73% 96.77% 91.50% 89.39% 93.89% 89.45% 86.97% Panel B: Value-weighted portfolios 34.22% 87.43% 71.00% 73.46% 72.50% 62.06% 62.78% 96.52% 90.63% 88.82% 93.85% 88.58% 86.46% 15.37% 88.50% 70.87% 73.70% 74.13% 62.77% 63.80% 96.02% 89.42% 87.28% 93.29% 87.84% 85.16% 9.69% 87.56% 67.60% 70.71% 74.74% 60.88% 61.83%

Table B2 Sensitivity of results to different models (cross-sectional estimates of firm-specific risk) The first row in Panel A reports the average annual return difference for randomly-selected portfolios in the top and bottom return deciles. Results are computed each year between 2000 and 2004 and averaged over the five years. The next six rows report the estimated fraction of the return difference attributed to cross-sectional estimates of firm-specific risk based a market model, a three-factor model (market, size, and value/growth factors), a four-factor model (market, size, value/growth, and momentum factors), a market model that includes 49 industry intercepts each week, a three-factor model that includes 49 industry intercepts each week, and a four-factor model that includes 49 industry intercepts each week. Panel B reports analogous figures for value-weighted portfolios. Number of securities in portfolio 10 50 100 500 1,000 Panel A: Equal-weighted portfolios Annual return difference 82.80% 36.55% 26.10% 10.96% 7.26% Percent of return difference due to firm-specific factors Market model 95.40% 95.18% 95.67% 95.50% 94.54% Three-factor model 90.91% 90.69% 91.12% 90.98% 89.63% Four-factor model 85.62% 85.28% 85.41% 85.47% 83.77% Market model + industry factor 89.15% 88.63% 89.41% 89.12% 88.31% Three-factor model + industry factor 85.33% 84.96% 85.64% 85.28% 83.88% Four-factor model + industry factor 80.64% 80.24% 80.76% 80.58% 78.77% Panel B: Value-weighted portfolios Annual return difference 74.66% 44.66% 34.22% 15.37% 9.69% Percent of return difference due to firm-specific factors Market model 82.10% 80.57% 81.34% 82.29% 80.67% Three-factor model 77.23% 75.40% 74.33% 73.38% 72.06% Four-factor model 69.87% 68.29% 67.91% 66.83% 63.91% Market model + industry factor 72.24% 69.49% 69.24% 70.27% 72.10% Three-factor model + industry factor 68.24% 63.27% 60.67% 59.52% 60.62% Four-factor model + industry factor 62.79% 58.30% 56.67% 55.27% 55.13%

Figure B1: Annual Average Deviation from Equal-Weighted Market Return (2000-2004) for Top and Bottom Deciles of Random Equal-Weighted Portfolios formed from All Stocks and from Large Stocks Only (capitalization > median capitalization) )
60% 50% 40%

All stocks: Average total excess return for top decile

Annual Deviation from Market Return

Large stocks only: Average total excess return for top decile
30% 20% 10% 0% 10 -10% -20% 20 30 40 50 60 70 80 90 100

Large stocks only: Average total excess return for bottom decile
-30%

All stocks: Average total excess return for bottom decile

-40%

Number of Securities in Portfolio

Figure 1 - Typical Representation of Number of Securities and Firm-Specific Risk

Annual Standard Deviation

Firm-specific risk

Market risk

Number of Securities in Portfolio

Figure 2 - Total Risk, Market Risk, and Firm-Specific Risk (2000-2004)

30%

25%

This is not firm-specific risk for a 50 stock portfolio

Annual Standard Deviation

20%

15%

10%

This is firm-specific risk for a 50 stock portfolio

5%

0% 0 50 100 150 200 250 300 350 400 450 500

Number of Securities in Portfolio

Figure 3A: Annual Time-Series Variance for Random Equal-Weighted Portfolios of 10 to 4000 Securities (2000-2004)
18%

16%

14%

12%

Annual Variance

10%

8%

Average systematic variance top decile Average total variance top decile Average total variance

6%

4%

2%

Average total variance bottom decile Average systematic variance bottom decile
0 500 1000 1500 2000 2500 3000 3500 4000

0%

Number of Securities in Portfolio

Figure 3B: Annual Time-Series Variance for Random Equal-Weighted Portfolios of 10 to 100 Securities (2000-2004)
18%

16%

14%

Average total variance top decile

12%

Annual Variance

10%

Average systematic variance top decile Average total variance

8%

6%

4%

2%

Average systematic variance bottom decile

Average total variance bottom decile

50 60 70 80 90 100

0% 10 20 30 40

Number of Securities in Portfolio

Figure 3C: Annual Time-Series Variance for Random Equal-Weighted Portfolios of 100 to 1000 Securities (2000-2004)

5.30%

Average total variance top decile

4.80%

Annual Variance

4.30%

Average systematic variance top decile

3.80%

Average total variance Average systematic variance bottom decile

3.30%

Average total variance bottom decile

2.80% 100 200 300 400 500 600 700 800 900 1000

Number of Securities in Portfolio

Figure 3D: Annual Time-Series Variance for Random Equal-Weighted Portfolios of 1000 to 4000 Securities (2000-2004)

4.00%

3.90%

Average total variance top decile

3.80%

Annual Variance

3.70%

Average systematic variance top decile

3.60%

Average total variance

3.50%

Average systematic variance bottom decile

3.40%

3.30%

Average total variance bottom decile

3.20% 1000

1500

2000

2500

3000

3500

4000

Number of Securities in Portfolio

Figure 4A: Annual Average Deviation from Equal-Weighted Market Return for Top and Bottom Deciles of Random Equal-Weighted Portfolios of 10 to 4000 Securities (2000-2004)
60% 50% 40%

Annual Deviation from Market Return

30% 20% 10% 0% 0 -10% -20% -30% -40% 500

Average systematic excess return for top decile

Average total excess return for top decile

1000

1500

2000

2500

3000

3500

4000

Average total excess return for bottom decile

Average systematic excess return for bottom decile Number of Securities in Portfolio Figure 4B: Annual Average Deviation from Equal-Weighted Market Return for Top and Bottom Deciles of Random Equal-Weighted Portfolios of 10 to 100 Securities (2000-2004)

60% 50% 40%

Average total excess return for top decile

Annual Deviation from Market Return

Average systematic excess return for top decile

30% 20% 10% 0% 10 -10% -20% 20 30 40 50 60 70 80 90 100

Average firm-specific return for top decile

Average firm-specific return for bottom decile

Average systematic excess return for bottom decile

-30%

Average total excess return for bottom decile

-40%

Number of Securities in Portfolio

Figure 4C: Annual Average Deviation from Equal-Weighted Market Return for Top and Bottom Deciles of Random Equal-Weighted Portfolios of 100 to 1000 Securities (2000-2004)
15%

Average total excess return for top decile

10%

Average systematic excess return for top decile

Annual Deviation from Market Return

5%

Average firm-specific return for top decile

0% 100

200

300

400

500

600

700

800

900

1000

Average firm-specific return for bottom decile

-5%

Average systematic excess return for bottom decile

-10%

Average total excess return for bottom decile

-15%

Number of Securities in Portfolio Figure 4D: Annual Average Deviation from Equal-Weighted Market Return for Top and Bottom Deciles of Random Equal-Weighted Portfolios of 1000 to 4000 Securities (2000-2004)
4%

Average total excess return for top decile

3%

Average systematic excess return for top decile

Annual Deviation from Market Return

2%

1%

Average firm-specific return for top decile

0% 1000 -1%

1500

2000

2500

3000

3500

4000

Average firm-specific return for bottom decile

-2%

Average systematic excess return for bottom decile

-3%

Average total excess return for bottom decile

-4%

Number of Securities in Portfolio

Figure 5A: Annual Average Deviation from Value-Weighted Market Return for Top and Bottom Deciles of Random Value-Weighted Portfolios of 10 to 100 Securities (2000-2004)
40%

Average total excess return for top decile

30%

Annual Deviation from Market Return

20%

Average systematic excess return for top decile

10%

Average firm-specific return

0% 10 -10% 20 30 40 50 60 70 80 90 100

Average firm-specific return

-20%

Average systematic excess return for bottom decile

-30%

Average total excess return for bottom decile

-40%

Number of Securities in Portfolio Figure 5B: Annual Average Deviation from Value-Weighted Market Return for Top and Bottom Deciles of Random Value-Weighted Portfolios of 100 to 1000 Securities (2000-2004)

17%

Average total excess return for top decile Average systematic excess return for top decile

12%

Annual Deviation from Market Return

7%

Average firm-specific return

2% 100 -3% 200 300 400 500 600 700 800 900 1000

Average firm-specific return

-8%

Average systematic excess return for bottom decile

-13%

-18%

Average total excess return for bottom decile Number of Securities in Portfolio

Figure 6: Annual Average Difference Between Top Decile Average Return and Bottom Decile Average Return for Random Portfolios of 20, 50, 100, and 500 Stocks over Time (1966-2004)
90%

20-Stock Portfolios
80%

50-Stock Portfolios
70%

100-Stock Portfolios 500-Stock Portfolios

60% Annual Return Difference

50%

40%

30%

20%

10%

0% 1966

1971

1976

1981

1986

1991

1996

2001