Diversification is important now more than ever

The last three months have seen big swings in the world’s stock markets. Over that period, the performance of five of the most important has been as follows: Europe +10 per cent, UK +6 per cent, China +2 per cent, Japan +1 per cent, and the US -6 per cent. In the prior 12 months, the equivalent figures were: US +29 per cent, Japan +19 per cent, China +19 per cent, Europe +9 per cent, and the UK +9 per cent.

The inversion of this leaderboard has been both the cause and the consequence of one of the biggest and quickest ever flights from Wall Street. According to Bank of America, allocations to US shares fell from 17 per cent above a neutral weighting to 23 per cent below it between February and March.

Two things are worth noting. First, the performances are divergent. The difference between the best and the worst in both periods is wide. Second, the most recent figures are the mirror image of the earlier ones. Both comparisons make a case for diversification because, while the divergence was to be expected, the identity of the winners and losers - and the timing of the move - was not.

Diversification is motherhood and apple pie in investment. Everyone believes it is a good thing. I have always employed it when allocating my own investments, and I have for many years divided my self-invested pension using a simple, possibly over-cautious, ten-way split.

If anything, diversification is more important to me now than ever. That is because my days of accumulating my retirement savings are largely in the past and, as I look towards drawing an income from them, a smooth ride and capital preservation are more of a priority than shooting the lights out in performance terms. I am more conscious than I used to be of Warren Buffett’s first rule of investment: do not lose money.

I was delighted, therefore, that the clever people behind the UBS Global Investment Returns Yearbook made diversification their focus in this year’s edition. They have crunched their 125-year database to answer a few key questions about diversification. The first of these is why it matters. And it is this question that delivers the killer stats.

Citing a range of recent studies from the US and elsewhere, London Business School professors Marsh, Dimson and Staunton note that 57 per cent of US shares have delivered worse returns than cash while just the best-performing 4 per cent of companies are responsible for the entire performance of the US stock market over the last 100 years.

The outsize returns for shares - the ones routinely quoted to justify investment in stocks rather than bonds or cash - are driven by the performance of very few investments. Seventeen shares have turned a dollar into at least US$50,000. They completely skew the overall figures. Not holding the handful of winners makes it very unlikely that you will match the market average returns.

There is talk today about how undiversified the US stock market has become. And this concentration is presented as an excuse for the underperformance of stock-picking funds. There is some truth in this. The largest ten stocks accounted for 34 per cent of the value of the US stock market last year. Not holding those shares in that proportion has made it hard to keep up.

But there is more to concentration than meets the eye. Although the US market is more concentrated today than in 90 years, this is not that unusual in historic terms. Concentration was similar from the 1930s to the 1960s. And it is not alone. Of the world’s top 12 markets, only India and Japan are less concentrated than the US. In Taiwan, for example, one stock - Taiwan Semiconductor - accounts for more than half the value of the country’s shares. Market concentration is less important than concentration of performance. The problem is not that the Magnificent Seven represent a third of the value of the US stock market, but rather that they delivered 63 per cent of the market return in 2024. Being more diversified than the market has been a headwind for investors while tech outperformed. As it falls back to earth, diversification will be much more helpful.

Another conclusion from the UBS study is that the benefits of diversification are variable depending on the markets from which and into which you are diversifying. As a US-based investor you have gained little from spreading your bets over the past five decades or so. Since 1974 Americans have earned better risk-adjusted returns by staying at home. The same is not true of investors in most other countries, including our own. Despite the US outlier, the evidence is that investing globally has made, and will continue to make, sense. Investing from developed into emerging markets also looks more powerful than balancing a portfolio within developed markets.

One final observation about diversification is relevant today. Correlations between and within markets tend to increase in bear markets and times of crisis. That makes intuitive sense. When investors rush to the exit, they do so in an indiscriminate way. But importantly these ‘sell everything’ moments tend to be short-lived and are only a problem if you are a forced seller - a good argument for your diversification strategy to always include a healthy dollop of cash. It is also the case that stocks and bonds behave differently during a crisis. When they are most needed - when stock markets are moving in tandem - government bonds can be an excellent diversifier. So can gold.

Diversification does not always work. But those times are only ever clear with the benefit of hindsight. As investors we do not enjoy a rear-view mirror. A sensible strategy does not always deliver the best outcome. That does not make it wrong.

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Please note that the views expressed in this article are my own.