Why Diversification Still Matters

Conventional wisdom suggests that diversification is the only free lunch in investing, and investors have historically been encouraged to diversify both within and across asset classes. Within an asset class, holding a broad range of securities reduces the company-specific risk associated with concentrated exposure to a single stock. Across a portfolio, exposure to a variety of asset classes, such as bonds and non-U.S. equities, has traditionally provided diversification benefits and lower volatility. For example, from 2000 to 2020, a diversified 60/40 portfolio produced better returns (+229%) than a global all-equity portfolio (+182%) with less risk, as measured by volatility. ¹

However, for several years leading up to 2025, if an investor owned virtually anything other than the S&P 500, they likely underperformed and sacrificed return. This was largely driven by outsized returns from a handful of large technology stocks that dominated index performance and collectively represented an average weighting of 37% in 2025.² In fact, an investor who simply owned the seven largest technology companies in the index over the last several years would have generated returns far in excess of the broader market.

Investors in recent years have not been rewarded for diversification, and many began to wonder whether the traditional 60/40 portfolio was dead. This sentiment was reinforced in 2022, one of the worst years on record for balanced portfolios, as the Federal Reserve rapidly raised interest rates to combat inflation. Bond prices fell, yields rose, and equities corrected amid fears of an impending recession. The result was a historically challenging year for both stocks and bonds.

More recently, we have started to see some of the traditional benefits of a diversified portfolio again. Over the last 18 months (from 1/1/2025 to 6/30/2026), small cap stocks, non-U.S. developed stocks, and emerging market stocks have all outperformed the S&P 500. During this period, investors with exposure to these asset classes produced superior returns.

Importantly, bonds in diversified portfolios today are contributing meaningfully to overall performance in two different ways. First, with yields having normalized, a portfolio holding a combination of municipal, investment grade, and high yield bonds has the potential to generate a return on fixed income of 5.8% on a taxable-equivalent basis.³ Bonds today are doing something they have struggled to do since 2008: contribute meaningfully to portfolio total returns. Second, we have recently seen bonds perform their other important role in a portfolio: providing downside protection and reducing volatility. While it was a relatively short episode, the peak to trough drawdown in equities from January 28 to March 30 of this year saw equities fall between -7-9%.2 During that time, municipal bonds fell -1.2%, investment grade bonds fell -0.4%, and high yield bonds fell -1.3%.² Investors in a balanced, diversified portfolio experienced a smaller drawdown and a quicker recovery, which is one of the most important reasons to include fixed income in investment portfolios.

The final important benefit of diversification relates to domestic equities and the “artificial intelligence” trade that is currently taking place. As mentioned, much of the recent market performance has been driven by large technology companies that are all competing to develop the most compelling AI products and services. This has resulted in significant capital expenditures, elevated stock prices, lofty valuations, and uncertain returns on investment. Given that these large technology companies make up such a significant percentage of the S&P 500 Index, and that they are exposed to many of the same risks (including the success of AI), we think it makes sense to own assets that are less correlated to them and exposed to different risk factors.

At Tolleson, we are focused on investing for the long term and through various market cycles. We are consistently reminded that investing is a long-term endeavor, and one of the most important decisions an investor can make is to remain invested. While portfolios evolve over time, maintaining exposure to a diverse set of asset classes and sticking with them through volatile and uncertain periods remains important. The historical benefits of diversification are well documented, and after several years of market concentration, those benefits are becoming easier to see again.