Nobel Laureate Harry Markowitz famously referred to diversification as “the only free lunch in finance.” What exactly did he mean by that? His point was that by diversifying across multiple investment options, investors could reduce risk without reducing expected returns or, alternatively, improve expected returns without increasing risk at the portfolio level.
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The goal, Markowitz wrote, was to find a risk-appropriate spot on the “efficient frontier” and implement a portfolio that occupied a place on that line, where returns were maximized for a given level of risk, and risk was minimized for a given level of return.
The math here involves correlation coefficients and other fun statistical stuff, but we’re going to move ahead in this discussion by stipulating that the broad benefits of portfolio diversification, both within and across asset classes such as stocks and bonds, have occupied center stage in the asset management world for over half a century.*
But a funny thing happens to diversified investors: They notice that their portfolios always underperform their best-performing components. So it’s tempting to wonder, during a period when one part of a diversified portfolio “works” and other parts “don’t,” why we’re diversified in the first place. Why, this line of thinking might go, do we own so much of B, C, and D, when A is running the table like this?
One answer is humility in the face of uncertainty. The reality is we simply didn’t know A would dominate over a given period before it did so. Hindsight is 20/20, but it’s also the source of a lot of needless regret and FOMO. “I should’ve known!” Not really. You had no way of knowing. That’s why you should have been diversified in the first place, to balance your risks and opportunities.
Part of an investor's perspective on diversification depends on his or her place on the optimism/pessimism scale. Optimists might look at a diversified portfolio and think to themselves, “Hey, it’s great that I’ve had some meaningful exposure to A.” Pessimists might think “Look at all the returns I’ve missed out on by having so much of my portfolio in B, C, and D.”
I’ve been thinking of these things lately in the context of the persistent, remarkable dominance of large-cap U.S. stocks over the last 15 years. Since the S&P 500 bottomed in March of 2009, it has been an absolute ripper to the upside. Sure, we’ve experienced semi-challenging spots like 2018 and genuinely challenging periods like the whiplash Covid Spring of 2020 and the nasty bear market of 2022. But overall, 15-year returns in the S&P 500 have been once-in-a-generation-if-you’re-lucky type of stuff.
Have a look at the adjacent chart, which shows total returns in several major asset classes. In absolute terms, all categories north of emerging market equities have done reasonably well. In relative terms, however, there’s a runaway winner: the biggest U.S. stocks.
The emotional and intellectual challenge of diversification is magnified when the top dog in the yard is the one whose name headlines CNBC and the nightly news Every. Single. Day.
So here we are, at the tail end of that chart, with the S&P 500 dusting everything else in the race for 15 years. What are we to do now? Pile in and pile on? Before we answer that question (with a crystal-clear “no”), let’s imagine a counterfactual, a very different version of the last decade and a half of market history.
In this alternate reality, it wasn’t the S&P 500 that led the way, but emerging market equities. If EM stocks had gone full Secretariat—they’re appreciating like a tremendous machine!—on the rest of our diversified portfolios, would we be tempted to jump in there now, after all this? Does that seem prudent?
None of this is to say I’m predicting U.S. under-performance. None of this is to predict anything at all. And that’s the point. When we confront the many questions raised by persistent, inevitable uncertainty, our best answer is diversification. After all, how long a time series (i.e., how many independent data points) would we need to draw definitive conclusions about whether a given asset class or strategy “works”? The answer is a lot of data over a very long period of time. In light of that, my view is that investors should aim for true diversification, not just within and across asset classes, but among investment strategies as well.
There’s a lot to be said for the resilience and dominance of the U.S. economy. We’re operating in the most dynamic, most flexible, most successful market on the planet right now, and it makes sense that the leading companies in the world’s most powerful economy would have delivered great returns. But that’s no guarantee that those returns will (or even should) continue. I took enough stats classes as a grad student at Wisconsin to become a committed believer in mean-reversion, the tendency of things that have strayed from their long-term averages to move back in the direction of those averages. And the reality of mean-reversion seals the argument for diversification.
Last thought for now: The rewards earned by diversifying investors are likely to be the highest precisely when diversifying feels the most difficult, the most frustrating, even pointless. This is especially true for those in the accumulation phase of their financial lives, those making regular contributions to diversified portfolios. What have those investors been doing while the S&P 500 produces this remarkable run? They’ve been participating in that run and acquiring assets in other corners of the market where prices (i.e., valuations) are more reasonable and thus imply higher future expected returns when things revert to their means.
My suggestion is to trust in the power of diversification and take comfort in the inevitability of mean-reversion. It can be challenging to stick with a genuinely diversified portfolio, but it’s still the right thing to do.
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* Markowitz published his groundbreaking paper on Modern Portfolio Theory in 1952; he accepted the Nobel Prize in Economics in 1990.