How Many Baskets For Your Eggs?

Do not put all your eggs in one basket, as the saying goes. In other words: do not invest all your money in a single stock (or single bond), but diversify it over a broader portfolio. That brings up the question: how many securities is enough to diversify? The question is all the more relevant in the current volatile market environment. Should it be five stocks, 20, 100 or 2,000?

In academia often the rule of thumb is given that one needs no more than 30 stocks in a portfolio, provided that they are well diversified over countries and sectors. But not everyone agrees.

The proof of the pudding is in the eating, so let’s test it ourselves. As a universe, we take all the 250 stocks that are in our VanEck Global Equal Weight UCITS ETF. We will then analyze how the volatility of a portfolio evolves, based on the number of stocks taken from that universe.

But first let’s define volatility. Basically it is a risk measure that shows how much percent a portfolio moved up or down per year in the past¹.

In the following figure we plot on the horizontal axis the number of stocks in the portfolio and on the vertical axis the volatility. What can be seen is that going from one stock to two stocks strongly reduces volatility. The same holds for going from two to five stocks. However, from five to ten the impact reduces. Eventually, the curve flattens at 30 stocks, meaning that adding still more stocks to a portfolio hardly brings any benefits from a diversification point of view. So the academics are right!

Figure 1 – Volatility falls as the number of stocks rises

Historical returns are not a reliable indicator for future returns. Source: VanEck analysis. Each data point if based on the full universe of the VanEck Global Equal Weight UCITS ETF. I.e., the average volatility of 32% for a one-stock portfolio is the median volatility of all 250 stocks in the universe. The average volatility of 27% for a two-stock portfolio is the median volatility of 124 combinations in the universe, etc. Data for the period 1/1/2000 - 28/4/2020.

So how can you reduce your volatility still further? Add bonds! Bonds are far less volatile than stocks and their prices tend to move in the opposite direction of share prices. As a result, they allow to reduce the overall portfolio’s volatility further.

We can see the results in figure 2. The horizontal axis plots the share of bonds in a portfolio. Everything else is invested in stocks. So, when bonds are zero, then the portfolio consists entirely of stocks. The resulting graph confirms the diversifying effect of bonds.

Figure 2 – Adding bonds cuts volatility even more

Historical returns are not a reliable indicator for future returns. Source: VanEck analysis. Stocks are represented by the VanEck Global Equal Weight UCITS ETF. Bonds are represented by the VanEck iBoxx EUR Sovereign Diversified 1-10 UCITS ETF. Data for the period 1/1/2012 - 28/4/2020.

For those who prefer not to spend too much time on counting stocks, they can simply invest in our ETFs. The following table shows that all our regional equal weight equity ETFs are well diversified:

And for those who prefer not to figure out the optimal mix between stocks, bonds and other asset classes, we provide the VanEck Multi-Asset Allocation ETFs. These invest in equities, sovereign bonds, corporate bonds and real estate stocks. You can choose from conservative, balanced and growth variants, depending on how much risk you want to take. Both volatility and return are lower for the conservative version and higher for the growth version, as the table below shows.

Historical returns are no reliable indicator for future returns. Returns are total returns based on gross dividends reinvested. Source: VanEck. Data since inception of the ETFs (14/12/2009) – 27/4/2020.

Of course, if ever there was a time that shows the wisdom of spreading your eggs across many baskets, it’s today. 2020 experienced the fastest fall in equity prices ever as the pandemic spread. But diversification cushioned the falls in portfolios. Looking to the future, there will come a time when today’s crisis no longer dominates headlines. But then, too, diversification will smooth your investment returns.