Index construction

		Isn't averaging like diversification; cancelling out vulnerability to one stock? <
		Then a larger number of stocks in an index will give more diversification -- isn't that a good thing? Why don't we put all the stocks of the country into the index?

Isn't averaging like diversification; cancelling out vulnerability to one stock?
Yes, the averaging that takes place in an index is equivalent to diversification. Diversification cancels out individual stock fluctuations. From an investment perspective, diversification reduces risk. From an information perspective, diversification cancels out stock noise; the only thing left after good diversification is the common factor -- news such as nuclear bombs -- which hits all stocks and cannot possibly be removed by diversification.

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Then a larger number of stocks in an index will give more diversification -- isn't that a good thing? Why don't we put all the stocks of the country into the index?
It is, indeed, the case that putting more stocks into an index yields more diversification. However, two things go wrong when we do this too much: First, there are diminishing returns to diversification. Going from 10 stocks to 20 stocks gives a sharp reduction in risk. Going from 50 stocks to 100 stocks gives very little reduction in risk. Going beyond 100 stocks gives almost zero reduction in risk. Hence, there is little to gain by diversifying, beyond a point. The more serious problem lies in the stocks that we take into an index when it is broadened. If the stock is illiquid, the observed prices yield contaminated information and actually worsen an index.

Last updated on March 10, 2008.