The following is an article that has been assigned to you. you should read the article at least a couple of times to familiarize yourself with the topic. if there are still concepts that are murky to you you are encouraged to consult the attached supplemental material, your textbook, or Google it on the internet. USE THE ARTICLE BELOW THE QUESTIONS TO ANSWER.

Questions:

1. Define the concept of diversification. there are many different definitions, depending on the circumstances. But in this case we want to know what is diversification in the context of investments.

2. According to the author what is the best way to diversify a stock portfolio? What is the advantage of this method?

3. From the performance and diversification standpoint, what is the biggest drawback to "investing in what you know," given you may know just a handful of companies?

4. The S & P 500 index has been the benchmark for diversification in the US, but according to the author this index doesn't provide the maximum diversification, why? what are better alternatives?

5 Myths About Stock Diversification No. 1: You don't really get much benefit going beyond 12 to 18 stocks. Wrong. Wrong by Meir Statman [WS], Alig. 8, 2020] Dtverstflication is often described as the only free lunch in investine - reducins a porufolio's risk without reducing expected return. This idea of spreading money acruss different kinds of investments is so accepted and so stralehtforward that it is a fundamental principle that even the most unsophisticated investors know about it. But while many individual investors think they understand diversification, they often fall prey to certain myths that koep them from fully partakine in this froc lunch. Firsu let's look at how diversilfication reduces risk Investors commonly assess the risk of a portiollo by the volatillty of Its returns, which is usually measured by slandard devlation, or how widely prices range from the average price. The standard devation of portifollo returns doclines with each slock (or trivestment) added. There is, however, a better way to understand diversification: It ensures that your money is never concentrated In the worst-performing assets, thus saving you from belng a bottom Itrvestor. To Illustrate, compare a porttollo of one stock to a better-dlversitled porttollo, composed of two stocks, A and D. During any given year, one stuck will return 22% and the uther minus 6%, but you don't know whalch stock will turn in the posltive performance and which the negathe. A portollo composed only of A or only of B would yield either 22%, malking you a tup investor, or minus 6%. making you a bockom investor. But a diversiffed portfollo of A and B, 5 ay in 50.50 proportions, would make you a mediocre investor, with a return of Q2 Diversification bloclos you from being a tup investur. Dut by eliminating the risle that yuu will ever be a buttum investor, it provides a safer way to make your money grow over time. Here, then, is a look at some diversification myths and horv they can hurt investors: Myth 1: Diversifying a portfolio beyond 12 to 18 storks offers no benefits. Many investors, Including ittvestment experts, note that you can obtain thore than 9096 of the henefits of diversification by cowning just 12 to 18 storks. That statement is true, hut the implication that there is no henefit to extending diversifiration bepond 12 to 18 stocks is a myth. More diversification always parys off-as long as the benefits of adding an investment exceed the costs of making the addition. To illustrate, imagine that T place 19 gold coins in font of you and say that you can take as many 26 yu like. Now suppose you have taken 18 of the coins, amounting to more than 94% of the 19 coins. Would you stop, ar take the 19th? As you contemplate your chaice you ask yourself what is the markinal beneelt of taking the 19 th coin? Say it is $1,000, the coln's worth. What is the marginal cost of taking that coin? Virtually nothing, just a flick of your fingers. The chaice is simple. Get the 19 th coln So whille the marginal bettefits of increasing diversification from 18 stocks to 19 stocks thay be small, the marginal costs of increasing diversification from 18 stochs to 19 are essentially zera when livesting in an Index fund or ETr contalnaing thousands of stocks, way more than 19 , and charging a 0.04% anmual fee Ta be sure, the cost of diversification is enormous if you diversify on your mwn into thousands of stocks or other investuents with high expenses. Efficient diversification is accomplished by lowmost index funds or ETFs. Myth 2: Owning, a handful of stocks you know is safer than a portfolio of thousands of stocks you don't know. "Lnvest in what you know." How many times have we beard that? Too many, it scems. A recent study from researchers at the University of Colorado found that many investors are convinced that a smaller portifulio composed of companies they lonesv and understand is much less risky than a diversifted porffolio of thousands of companies they don't know. When investors have too many stocles to research and monitor, they are likely to miss something important and lose their competitive edec or so the thinkine poes. In reality, mnst of the returns of the market over time are generated by a very small number of stoclos. A 2018 study published in the Journal of Finanrial Fconnmirs found that the hestperforming 4% of stocks each year collectively account for the total palin of the stock market sluce 1926. If you choose to own only a fraction of the more than 3,500 puhlirly traded stocks in the 11S, what are your adds of pirking exactly the right ones? They are very small, probably similar to picking a winning lottery ticket. If you deride to invest in virtually all of the publicly listed stocks in the UIS. through a tatal storkmariket index fundi, however, the adds that you will hold tomorrow's higgest winners are essentially 100% Therefore, partfolios of 12, 18 or even hundreds of storics are likely to lag behind a diversified index fund containing almost all stocks over time becduse the undiversifled portfolio is likely to miss the "super stocks' that will be driving most of the market's future returns. Myth 3: Owning an index fund provides you with diversification. An SEP 500 index fund is more diversified than a portfolio composed of a handful of stociss. But an S8.P 500 fund lisn't nearly as diverstfled as a total stock-market index fund. That's because the S\&P 500 index comprises mostly large-capitalization companies, or thase with relatively large total value of all their shares. In any year, the return of an index fund of large-cap stocks is likely to be different than the return of an index fund composed of small-cap stocks. And the returns of both are likely to differ from that of a total stock-market index fund, which includes both large- and small-cap companles. A look at Vanguard's index funds illustrates this point. In 2003, the return of Vanguard 500 Index Eund dminal shares (VFLAX), a fund that seeks to track the performance of the S\&P 500 , was 28.6%, while the return of Vanguard Small-Cap Index Fund Admiral (VSMAX) was 45.8\%. The return of Vanguard Total Stock Market Index fund (VTSAX) that year was 31.4\%, in between the returns of the two index funds, reflecting its greater diversification. In other years, swch as 2017 , the return of the sep 500 index fund exceeded that of the small-cap fund, but the return of the total stock-market index fund was in between, as always. The same concept holds true for index funds focused an value stocks, growth stocks, high-dividend stocks and so on. Their returns will reflect one slice of the market and could differ substantially from that of the stuck market as a whole. Those interested in building a diverse portfolio might start with three index funds: a total U.S. stock fund, a total international stock fund and a total bond fund. From there, Investors can flne-tune, based on their individual needs and goals Myth 4: U.S. and international stocks are closely correlated, so there is no diversification benefit in owning both. In general, when two investments are closely correlated, the difference in their returns is usually smaller and the diversification benefits of onning bath lawer. But correlation isn't the only factor investars should consider. The volatility of the two investments' returns also is important. When volatility [as measured by standard deviation) is high, the average difference between returns cau be high, which increases the diversification benefits of owning the investments. Looking at Vanguard index funds again, it is clear that U. . and international stocks are closely correlated. From 2000 to 2019, the correlation between the returns of Vanguard's total U.S. stock fund and its total international stock fund was 89%, not far from the 100% perfect correlation. But a look at their returns shows benefits of diversifying between U.S. and international stocis were great. For example, whereas the return of the total US stock fund in 2006 was 15.6%, the return of the total international fund that year was much higher at 26.6%. And whereas the return of the total U.S. stock fund in 2019 was 30.8%, the return of the total international fund that year was much lower, 21.5%. The difference in returns 11 percentage points in 2006 in favor of international stocks, and 9.3 percentage points in 2019 in favor of U.S. stocks - points to significant diversification betrefits in owning both types of stocks. The story of the returns of US. corporate bonds and U.S. government bonds complement the story. The correlation between the returns of the two kinds of bonds from 2000 to 2019 also was 899 , identical to the correlation between the returns of U.S. stocls and international stocks, but the volatility of the returns of bonds is lower than that of stocks. That resulted in smaller differences between the returns of two kinds of bonds than between the two kinds of stocks, and lower benefits of diversification between bonds. Myth 5: Market timing is necessary, in addition to diversification. Many Investors lost falth in diverstflcation during the financial crisis of 2008 , when both US. and international stocks were decimated. Vanguard's U.S. total stock-market index fund plunged 37% in 2009 , while its international stock-marloet index fund fell 44.1%. The difference in performance was 7,1 percentage points, indlcating substantial diverstflcation benefits, but these benefits eliclted few cheers. In contrast, an index fund of long-term bonds, combining U.S. corporate and government bonds, gained 8.8% that year. That led some Investmen pros to suagess that in additlon to diverslelcation, money managers should engage in so-cailed tactical methods, too. They were referring to tactical asset allocation, or timing the market. These pros imply that competent money manapers would have sold stocks and boughat bonds at the end of 2007 , avoiding the 2000 crash, and reverted back to stocks in time for 2009 , when the U.S. total stock-market index fund gained 28.8% and the total international stock. fatbarket index fund gained 36.7%. But market timing is easier said than dobe. Antateur itivestors trying to time the market tend to buy and sell at all the wrong times and end up underperforming their buy'and-hold peers. Diversification protects us from being bottom investors, as we abandon hope of being top investors. Successful marbet timing can make us top investors, but it is likely to be unsuccessful, turning us into bottom irvestors. That said, the two approaches can coexist, You can own a total stock-market index fund and then, in a different account, also make bets on a handful of stocks you believe will earn extraordinary returns. But investing in just a docen or so stocks and expecting extraordinary returns is just too risky for mst ittwstors. Dr. Stutman is the Glent Klimek professor of finance at Santa Clara Untuersity's business school and author of "Behaviorai Finance: The Second Gentration" (avallable free at ofalnstitute.ong]. 5 Myths About Stock Diversification No. 1: You don't really get much benefit going beyond 12 to 18 stocks. Wrong. Wrong by Meir Statman [WS], Alig. 8, 2020] Dtverstflication is often described as the only free lunch in investine - reducins a porufolio's risk without reducing expected return. This idea of spreading money acruss different kinds of investments is so accepted and so stralehtforward that it is a fundamental principle that even the most unsophisticated investors know about it. But while many individual investors think they understand diversification, they often fall prey to certain myths that koep them from fully partakine in this froc lunch. Firsu let's look at how diversilfication reduces risk Investors commonly assess the risk of a portiollo by the volatillty of Its returns, which is usually measured by slandard devlation, or how widely prices range from the average price. The standard devation of portifollo returns doclines with each slock (or trivestment) added. There is, however, a better way to understand diversification: It ensures that your money is never concentrated In the worst-performing assets, thus saving you from belng a bottom Itrvestor. To Illustrate, compare a porttollo of one stock to a better-dlversitled porttollo, composed of two stocks, A and D. During any given year, one stuck will return 22% and the uther minus 6%, but you don't know whalch stock will turn in the posltive performance and which the negathe. A portollo composed only of A or only of B would yield either 22%, malking you a tup investor, or minus 6%. making you a bockom investor. But a diversiffed portfollo of A and B, 5 ay in 50.50 proportions, would make you a mediocre investor, with a return of Q2 Diversification bloclos you from being a tup investur. Dut by eliminating the risle that yuu will ever be a buttum investor, it provides a safer way to make your money grow over time. Here, then, is a look at some diversification myths and horv they can hurt investors: Myth 1: Diversifying a portfolio beyond 12 to 18 storks offers no benefits. Many investors, Including ittvestment experts, note that you can obtain thore than 9096 of the henefits of diversification by cowning just 12 to 18 storks. That statement is true, hut the implication that there is no henefit to extending diversifiration bepond 12 to 18 stocks is a myth. More diversification always parys off-as long as the benefits of adding an investment exceed the costs of making the addition. To illustrate, imagine that T place 19 gold coins in font of you and say that you can take as many 26 yu like. Now suppose you have taken 18 of the coins, amounting to more than 94% of the 19 coins. Would you stop, ar take the 19th? As you contemplate your chaice you ask yourself what is the markinal beneelt of taking the 19 th coin? Say it is $1,000, the coln's worth. What is the marginal cost of taking that coin? Virtually nothing, just a flick of your fingers. The chaice is simple. Get the 19 th coln So whille the marginal bettefits of increasing diversification from 18 stocks to 19 stocks thay be small, the marginal costs of increasing diversification from 18 stochs to 19 are essentially zera when livesting in an Index fund or ETr contalnaing thousands of stocks, way more than 19 , and charging a 0.04% anmual fee Ta be sure, the cost of diversification is enormous if you diversify on your mwn into thousands of stocks or other investuents with high expenses. Efficient diversification is accomplished by lowmost index funds or ETFs. Myth 2: Owning, a handful of stocks you know is safer than a portfolio of thousands of stocks you don't know. "Lnvest in what you know." How many times have we beard that? Too many, it scems. A recent study from researchers at the University of Colorado found that many investors are convinced that a smaller portifulio composed of companies they lonesv and understand is much less risky than a diversifted porffolio of thousands of companies they don't know. When investors have too many stocles to research and monitor, they are likely to miss something important and lose their competitive edec or so the thinkine poes. In reality, mnst of the returns of the market over time are generated by a very small number of stoclos. A 2018 study published in the Journal of Finanrial Fconnmirs found that the hestperforming 4% of stocks each year collectively account for the total palin of the stock market sluce 1926. If you choose to own only a fraction of the more than 3,500 puhlirly traded stocks in the 11S, what are your adds of pirking exactly the right ones? They are very small, probably similar to picking a winning lottery ticket. If you deride to invest in virtually all of the publicly listed stocks in the UIS. through a tatal storkmariket index fundi, however, the adds that you will hold tomorrow's higgest winners are essentially 100% Therefore, partfolios of 12, 18 or even hundreds of storics are likely to lag behind a diversified index fund containing almost all stocks over time becduse the undiversifled portfolio is likely to miss the "super stocks' that will be driving most of the market's future returns. Myth 3: Owning an index fund provides you with diversification. An SEP 500 index fund is more diversified than a portfolio composed of a handful of stociss. But an S8.P 500 fund lisn't nearly as diverstfled as a total stock-market index fund. That's because the S\&P 500 index comprises mostly large-capitalization companies, or thase with relatively large total value of all their shares. In any year, the return of an index fund of large-cap stocks is likely to be different than the return of an index fund composed of small-cap stocks. And the returns of both are likely to differ from that of a total stock-market index fund, which includes both large- and small-cap companles. A look at Vanguard's index funds illustrates this point. In 2003, the return of Vanguard 500 Index Eund dminal shares (VFLAX), a fund that seeks to track the performance of the S\&P 500 , was 28.6%, while the return of Vanguard Small-Cap Index Fund Admiral (VSMAX) was 45.8\%. The return of Vanguard Total Stock Market Index fund (VTSAX) that year was 31.4\%, in between the returns of the two index funds, reflecting its greater diversification. In other years, swch as 2017 , the return of the sep 500 index fund exceeded that of the small-cap fund, but the return of the total stock-market index fund was in between, as always. The same concept holds true for index funds focused an value stocks, growth stocks, high-dividend stocks and so on. Their returns will reflect one slice of the market and could differ substantially from that of the stuck market as a whole. Those interested in building a diverse portfolio might start with three index funds: a total U.S. stock fund, a total international stock fund and a total bond fund. From there, Investors can flne-tune, based on their individual needs and goals Myth 4: U.S. and international stocks are closely correlated, so there is no diversification benefit in owning both. In general, when two investments are closely correlated, the difference in their returns is usually smaller and the diversification benefits of onning bath lawer. But correlation isn't the only factor investars should consider. The volatility of the two investments' returns also is important. When volatility [as measured by standard deviation) is high, the average difference between returns cau be high, which increases the diversification benefits of owning the investments. Looking at Vanguard index funds again, it is clear that U. . and international stocks are closely correlated. From 2000 to 2019, the correlation between the returns of Vanguard's total U.S. stock fund and its total international stock fund was 89%, not far from the 100% perfect correlation. But a look at their returns shows benefits of diversifying between U.S. and international stocis were great. For example, whereas the return of the total US stock fund in 2006 was 15.6%, the return of the total international fund that year was much higher at 26.6%. And whereas the return of the total U.S. stock fund in 2019 was 30.8%, the return of the total international fund that year was much lower, 21.5%. The difference in returns 11 percentage points in 2006 in favor of international stocks, and 9.3 percentage points in 2019 in favor of U.S. stocks - points to significant diversification betrefits in owning both types of stocks. The story of the returns of US. corporate bonds and U.S. government bonds complement the story. The correlation between the returns of the two kinds of bonds from 2000 to 2019 also was 899 , identical to the correlation between the returns of U.S. stocls and international stocks, but the volatility of the returns of bonds is lower than that of stocks. That resulted in smaller differences between the returns of two kinds of bonds than between the two kinds of stocks, and lower benefits of diversification between bonds. Myth 5: Market timing is necessary, in addition to diversification. Many Investors lost falth in diverstflcation during the financial crisis of 2008 , when both US. and international stocks were decimated. Vanguard's U.S. total stock-market index fund plunged 37% in 2009 , while its international stock-marloet index fund fell 44.1%. The difference in performance was 7,1 percentage points, indlcating substantial diverstflcation benefits, but these benefits eliclted few cheers. In contrast, an index fund of long-term bonds, combining U.S. corporate and government bonds, gained 8.8% that year. That led some Investmen pros to suagess that in additlon to diverslelcation, money managers should engage in so-cailed tactical methods, too. They were referring to tactical asset allocation, or timing the market. These pros imply that competent money manapers would have sold stocks and boughat bonds at the end of 2007 , avoiding the 2000 crash, and reverted back to stocks in time for 2009 , when the U.S. total stock-market index fund gained 28.8% and the total international stock. fatbarket index fund gained 36.7%. But market timing is easier said than dobe. Antateur itivestors trying to time the market tend to buy and sell at all the wrong times and end up underperforming their buy'and-hold peers. Diversification protects us from being bottom investors, as we abandon hope of being top investors. Successful marbet timing can make us top investors, but it is likely to be unsuccessful, turning us into bottom irvestors. That said, the two approaches can coexist, You can own a total stock-market index fund and then, in a different account, also make bets on a handful of stocks you believe will earn extraordinary returns. But investing in just a docen or so stocks and expecting extraordinary returns is just too risky for mst ittwstors. Dr. Stutman is the Glent Klimek professor of finance at Santa Clara Untuersity's business school and author of "Behaviorai Finance: The Second Gentration" (avallable free at ofalnstitute.ong]