That old diversification advice could be hurting your returns

• Despite the traditional wisdom of global diversification, US stocks have outperformed international markets significantly over the past decade, particularly driven by the tech boom.

• The classic 60/40 portfolio and global diversification strategies have lagged behind a simple S&P 500 investment. Only a small fraction of asset-allocation funds have outperformed the S&P 500 since 2009.

• Diversification sounds wise because it spreads risk, but it’s tough since something in your portfolio will always underperform. It means sacrificing the chance for a big win to avoid a big loss, just like Warren Buffett’s rule: "Don’t lose money."

Conventional wisdom would tell you to ditch your home bias and go global with your investments – because there are fantastic businesses everywhere. And when you look beyond your borders, you can diversify your portfolio and potentially boost its returns. Mind you, that theory is under a serious stress test, especially among US investors.The S&P 500’s global outperformance right now and over the past decade is making it seem awfully unappealing to look elsewhere. But before you toss out the whole idea, here are a few things you should consider.

The case for diversification.

When it comes to diversifying your investments, there are two main strategies: spreading your money across different asset classes or diversifying within those classes globally. The point is to reduce your risk and enhance your returns over time. So instead of putting all your eggs in one basket and betting it all on a single asset, like a stock or a bond, you spread your investments around.

This way, if one pick tanks, the others might cushion the blow, keeping your financial ship steady, even in choppy waters.Think of having the right asset allocation like home insurance. You never know when you’re going to need it, but you probably wouldn’t feel comfortable without it. That said…

Counterargument 1: US dominance.

Diversification sounds great in theory, but it hasn’t always delivered in practice. Over the past decade, if you’d just stuck with US stocks, you’d be laughing all the way to the bank. Year after year, US shares have been the top performers, driven by Corporate America’s money-making mojo. Everything else has been a ticket to underperformance. Today’s younger investors can’t even remember a time when the US didn’t rule the global markets.

Since 2009, US big-cap stocks have returned a whopping 14% annually, including dividends. Shares from other developed markets didn’t come close, returning just 7.4%. And emerging markets trailed even further behind, with just 6.9%.Annualized returns of different assets from 2009-2023. Sources: JPMorgan Asset Management, Bloomberg.Just look at Jack Bogle: the legendary founder of Vanguard and the father of index investing never saw the point of a global portfolio.

He always argued that US multinationals give you plenty of international exposure. And at this point, even die-hard globalists would have to admit that non-American stocks have just dragged down the returns of a US-only portfolio, even if they did slightly reduce its risk.

Counterargument 2: Cross-asset skepticism.

The idea of diversifying into different asset classes – for example, with a classic 60/40 portfolio (60% stocks, 40% government bonds) – has also come up against serious skepticism. The numbers don’t lie: money managers who followed the industry’s old-school advice and spread their investments across markets, geographies, and asset classes have been clobbered by those who simply bought the S&P 500 and put their feet up.

Of the 370 multi-asset funds that Morningstar tracks, only one has beaten the index since 2009. In fact, diversified portfolios have lagged behind the US big-cap stock index in 13 of the past 15 years – an almost unprecedented streak, according to Cambria Funds.Cambria Funds’ global asset-allocation model versus the S&P 500 ETF’s performance over time. Source: Cambria Funds.A group of academics tested the age-old wisdom of a diversified bonds and stocks portfolio across three dozen countries over 130 years. They found that a mix of half domestic, half international shares actually outperformed blended portfolios in both returns and capital preservation. Using a computer to run a million simulations for American households, researchers discovered that splitting money between stocks from home and abroad built an average of just over $1 million by retirement, compared to $760,000 for the 60/40 mix.

While the all-stock approach had deeper maximum losses, it wasn’t enough to derail long-term performance.Performance of different fund strategies across a sample of three dozen countries over 130 years. Sources: Aizhan Anarkulova, Scott Cederburg, and Michael S. O’Doherty, “Beyond the Status Quo: A Critical Assessment of Lifecycle Investment Advice”.

So here are some practical diversification tips.

Diversifying your investments might sound like a no-brainer, but let’s be real – it’s not always easy. The tricky thing is knowing that some part of your portfolio will always underperform. And you won’t know which part until it happens. Investing is all about trade-offs, and diversification is essentially sacrificing the chance for a home run to avoid striking out entirely. It’s a feature, not a bug, of spreading your bets in portfolio management.

As Warren Buffett wisely put it: the first rule of investing is “don’t lose money”, and the second rule is “don’t forget the first rule”.It’s worth remembering that there is never “a one size fits all” in investing. Diversification exists on a spectrum, depending on your needs.For example, if you still love US stocks but want to dial down your tech exposure, you could consider an equally weighted S&P 500 ETF like the Invesco S&P 500 Equal Weight ETF (ticker: RSP; expense ratio: 0.2%) or for non-US investors the iShares S&P 500 Equal Weight UCITS ETF (EWSP; 0.2%).If you’re a risk-taker who wants to skip bonds and dive only into shares, emerging markets could be your favorite playground.

Most international stock benchmarks, especially in developed markets, closely track the US market. European stocks are highly correlated with US ones, while emerging markets tend to move to their own drum but with a bit more volatility, offering a different kind of diversification. So if you’re venturing overseas, it may be wise to include emerging markets rather than developed market stocks in your non-US allocations.Finally, if you’re a fan of the classic portfolio mix, remember that investing is flexible. You don’t have to stick to the old faithful 60/40 split forever: you can change things up based on your risk appetite. Target-date ETFs could be a smart move on that front.

These funds adjust their asset mix automatically as you approach a specific date, usually your retirement. They aim for big gains early on with a heftier allocation to riskier stocks and then shift to safer bonds later to lock in those gains.

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