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Smaller stocks diversify risk in increasingly vulnerable market

Want to diversify investment risk? Think outside the basket.

That’s the message of a study co-authored by Avraham Kamara, a professor of finance at the University of Washington Foster School of Business. Kamara finds that the rising preponderance of institutional investors trading in bundles or “baskets” of large-cap stocks has led to a growing confluence of price movement over the past 40 years. As a result, the overall market has become increasingly vulnerable to systematic shocks.

The market has organized into what Kamara calls a “tiered divergence,” where larger stock returns increasingly move collectively while smaller stock returns move more independently. “The ones inside the club, so to speak, behave more like each other,” he says. “And the ones left out behave more idiosyncratically.”

So owning large, established stocks—even stocks representing a wide array of industries—offers substantially less protection against unexpected negative events. “In fact,” Kamara adds, “the smaller stocks offer greater ability to diversify risk than they did in the past, and they diversify risk better than large stocks do.”

A growing separation

The 2008 financial crisis is the latest major shock to the entire system. But modern financial history is riddled with market-wide panics sparked, in many cases, by the misfortune of a single company or industry.

To gauge whether the market is becoming more vulnerable to such unexpected events, Kamara and co-authors Xiaoxia Lou and Ronnie Sadka analyzed daily share prices of all the stocks on NYSE and AMEX from 1968 to 2008. They focused on the largest and smallest 20 percent of public companies. As institutional investors and index funds have grown in dominance, a growing divergence of price movement has occurred: large stocks now move together; small stocks move apart.

“When the market crashes, everything goes down together,” Kamara says. “But over the years, smaller stocks have become less sensitive to the market as a whole.”

Keep some eggs out of the basket

So what to do if you are an investor shaped by the mantra of diversification? According to Kamara, the old method of buying into large indices of high-quality companies from a wide variety of industries and sectors diversifies risk less effectively than in past years. To achieve a truly diversified portfolio today, you have to include small-cap stocks that reside outside of the baskets and indices.

“The moral of our story is: you still need to diversify,” Kamara says. “But you cannot diversify as effectively as you did in the past by just holding large stocks. You have to hold smaller stocks that aren’t in the leading indices to gain the benefits of diversification—especially during a crisis.”

Has the U.S. Stock Market Become More Vulnerable over Time?” by Avraham Kamara of the University of Washington Michael G. Foster School of Business, Xiaoxia Lou of the University of Delaware Alfred Lerner College of Business and Economics, and Ronnie Sadka of the Boston College Carroll School of Management, was published in the January/February 2010 Financial Analysts Journal.

Many of its findings were originally published in the paper “The divergence of liquidity commonality in the cross-section of stocks,” also by Kamara, Lou and Sadka, published in the 2008 Journal of Financial Economics.