Efficient Portfolio Diversification : Changing UK Stock Market Sector and Sub-Sector Volatilities, 1967-2000

Volatility in UK stock markets increased substantially during 1997-2000 relative to the past. This paper shows that much of that volatility can be attributed to a substantial increase in sector specific and sub-sector specific risk. Over this period the role of market risk as the driving force for overall volatility appears to have diminished. This result not only has implications for the validity of the market model but also means that investment managers should account for potential movements in sector specific and sub-sector specific risk. We find no evidence of an upward trend in sub-sector volatility but show that the number of sub-sectors needed to obtain any given amount of portfolio diversification has increased over time. While investors who specialise in one or two sub-sectors of the stock market face higher total risk than in the past, the benefits to diversification have increased and investing in a portfolio that contains at least four sub-sectors reduces specific risk by three per cent