Diversification in the Chinese Stock Market (original) (raw)

Modern finance theory suggests that individual investor should hold a well diversified portfolio instead of individual stocks. In practice, one only needs to hold limited number of stocks to achieve the effect of diversification. In this study, we revisit the same issue for the Chinese equity market in three different dimensions. They are (1) relative idiosyncratic risk and risk adjusted portfolio returns; (2) the likelihood of achieving diversification; and (3) turnover of a portfolio. Due to faster declining in the market volatility relative to the aggregate idiosyncratic volatility, one needs to hold 20 stocks in a portfolio in order to diversify away 90% of the total idiosyncratic volatility or equivalent to 95% of the market volatility nowadays. In addition, we have shown that holding one or two stocks will subject to huge negative risk adjusted returns. Therefore, Chinese investors can benefit greatly from diversification with a relatively long investment horizon.