Diversification in the Chinese Stock Market

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, that is reducing the idiosyncratic volatility. In this paper, we study the benefit of diversification in emerging markets, such as the Chinese equity markets, where idiosyncratic volatilities are relatively low and investors trade speculatively. We focus on three different dimensions: (1) the relative idiosyncratic risk and the risk adjusted portfolio returns; (2) the likelihood of achieving diversification; and (3) portfolio turnover versus diversification. 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 China. 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.