Why small portfolios are preferable and how to choose them

One of the fundamental principles in portfolio selection models is minimization of risk through diversification of the investment. However, this principle does not necessarily translate into a request for investing in all the assets of the investment universe. Indeed, following a line of research started by Evans and Archer almost 50 years ago, we provide here further evidence that small portfolios are sufficient to achieve almost optimal in-sample risk reduction with respect to variance and to some other popular risk measures, and very good out-of-sample performances. While leading to similar results, our approach is significantly different from the classical one pioneered by Evans and Archer. Indeed, we describe models for choosing the portfolio of a prescribed size with the smallest possible risk, as opposed to the random portfolio choice investigated in most of the previous works. We find that the smallest risk portfolios generally require no more than 15 assets. Furthermore, it is almost always possible to find portfolios that are just 1% more risky than the smallest risk portfolios and contain no more than 10 assets. The preference for small optimal portfolios is also justified by recent theoretical results on the estimation errors for the parameters required by portfolio selection models. Our empirical analysis is based on some new and on some publicly available benchmark data sets often used in the literature.