One of the key investment principles we emphasize at Core Wealth Management is that investing solely in US large company stocks does not provide sufficient diversification. True diversification requires spreading investments across different asset classes that behave differently at various times. This means building a globally diversified portfolio that includes US large company stocks (such as those in the S&P 500), as well as small company stocks, non-US stocks in both developed and emerging markets, and fixed income holdings.
Choosing to diversify away from large US stocks has been challenging in recent years. In 6 of the last 10 years, US large company stocks (as measured by the S&P 500) have outperformed US small company stocks (Dimensional US Small Cap Index), the stocks of developed nations outside the US (as measured by the MSCI World ex-US Index), and emerging market stocks (as measured by the MSCI Emerging Markets Index).
More significantly, from 2014 to 2023, the cumulative performance of US large company stocks was 211%, considerably higher than the returns for small company stocks at 128% and leaving stocks from outside the US in the dust, so to speak.
Due to the experience of the last 10 years, some might ask, is it time to abandon diversification and move on from the globally diversified portfolio?
We argue no, and especially not now. Here are five reasons why:
Five Reasons Not to Abandon Diversification
1. The S&P 500 is Not “The Market”
First, it’s important to remember that the reason the S&P 500 is often used as a yardstick for how “the market” is performing is because it is large, well-known, and easy for the media to report on. However, that doesn’t mean it is “the market.” The truth is that the S&P 500 only represents approximately 60% of the overall global market. Ignoring the other 40% of the global markets is like betting that a large portion of the global markets will always underperform, which can prove to be a risky and costly assumption.
Also important to consider is that the S&P 500 itself is becoming more concentrated. As of last quarter, the top 10 stocks in the S&P 500 accounted for 37% of the index!
2. Diversification Means Some Parts Will Always “Underperform”
In a diversified portfolio, it is expected that some investments will outperform while others underperform at any given time. In some sense, this is the point of diversification.
It would be great if we could predict which parts of the market would always do well, but without a crystal ball, that’s impossible. The best practical approach is to diversify across all areas of the market and systematically rebalance as the markets move. This way, market returns will be captured, and the portfolio stays on target.
3. Diversification is About Risk Management
A primary benefit of diversification is risk reduction. By spreading investments across a variety of asset classes, investors reduce the impact of poor performance in any single area. This helps achieve more stable and reliable returns over time. Abandoning diversification means taking on more risk than necessary without any assurance of higher returns.
4. Diversification is About Not Missing Out
Certain asset classes may experience significant periods of outperformance that are often unpredictable. Broad diversification helps ensure that investors capture these opportunities as they arise. For example, a portfolio that did not include emerging market stocks in the dismal 2000s missed out on an asset class that produced a cumulative return of 162%!
5. Diversification is Especially Important During the Withdrawal Phase
As investors enter the retirement phase and begin making withdrawals, diversification becomes even more critical. A well-diversified portfolio reduces volatility and helps avoid over-concentration in any single investment. This approach is especially beneficial during challenging periods, such as the “lost decade” of 2000-2009, when diversification preserved the financial security of many retirees.
Remembering the “Lost Decade” (2000-2009)
In the 1990s, much like the past decade, US large company stocks significantly outperformed small company stocks and non-US stocks. However, in the following decade, often referred to as the “lost decade,” it turned out quite differently.
The table below presents the returns of various asset classes from 1990-1999, 2000-2009, and 1990-2009. Note that the blended index presented consists of 50% S&P 500, 25% small company stocks, 15% non-US developed countries, and 10% emerging markets. This blended index represents a “diversified portfolio.”
As you can see, the S&P 500 went from dominating in the 1990s to producing a negative return for the entire decade of 2000-2009, its worst decade since the 1930s. Meanwhile, other asset classes performed much better. A portfolio that excluded small company stocks or emerging market stocks would have been significantly worse off. This is why, for the 10 and 20-year periods ending 12/31/2009, the blended index outperformed the S&P 500 with less risk.
This isn’t just about charts—there are real-world implications. Imagine an investor who retired in 2000 and only invested in S&P 500 stocks; by the end of the decade, they might have been forced to make dramatic changes to their retirement plans, such as returning to work or cutting back on spending. Retirees with a diversified portfolio would have fared much better, likely keeping their retirement plans on track.
Stay the Course
Diversification is the hallmark of evidence-based, thoughtful investing. It ensures that investors do not put all their eggs in one basket, thereby increasing the likelihood of achieving their financial goals, regardless of what the future holds.
Today, we face a moment very similar to the one faced by investors in early 2000. After a decade of S&P 500 dominance, the temptation to abandon diversification feels overwhelming. But perhaps the next ten years will prove to be like the 2000-2009 period, when a globally diversified portfolio, though out of favor, truly shined and served as a safeguard for retirees.