Why You Diversify

“Why should I own anything other than the S&P 500?”

This is the most common question investors are asking entering 2025.

Why are they asking it?

Because over the last decade, the S&P 500 has outpaced every other major asset class by a wide margin, gaining 13.1% per year versus 9.0% for U.S. small cap stocks, 6.6% for U.S. real estate, 5.8% for international stocks, 4.0% for emerging market stocks and 1.3% for U.S. bonds.

And within the S&P 500, the outperformance of the seven largest companies (aka the “Magnificent Seven” has been even more dramatic, with annualized returns ranging from 22% for Google to 76% for Nvidia.

Given this backdrop, it’s not surprising to hear investors question the benefits of diversification, asking why they should own anything other than just the S&P 500 (aka “the winners”).

This is a valid question to which there is one good answer: because no one knows with any certainty who “the winners” of the future will be.

Since we can’t accurately or consistently predict the future, prudence requires building a diversified portfolio that can withstand multiple possible outcomes.

And one of those possible outcomes is that the future will look different than the recent past, with large-cap U.S. stocks underperforming everything else.

Has that ever happened before?

Yes. There’s a cycle to everything in markets; nothing outperforms always and forever.

At the end of 2009, many were bemoaning the “lost decade” in which the S&P 500 declined 9% and U.S. growth stocks lost a third of their value. It may seem hard to believe, but back then investors were questioning whether large-cap U.S. stocks would ever regain their footing.

Fast forward to today, and not only did the largest U.S. stocks come back, but they’ve been so dominant for so long that it’s hard to imagine a scenario in which they’ll ever underperform again.

But that’s always the case after an unprecedent run. The longer it goes on, the more we believe in its permanence. This likely explains why fund managers were 36% overweight U.S. equities in the latest BofA survey, the highest level on record.

It also explains why U.S. equity valuations are now 86% higher than European shares, the widest valuation gap in history. Investors are paying an enormous premium for U.S. stocks under the assumption that the future will mirror the past.

The primary driver of that spread has come from multiple expansion within the Magnificent Seven names, none of which are trading at historically cheap levels.

Which is another way of saying that expectations for continued U.S. outperformance are exceedingly high today, which in turn increases the risk of these stocks underperforming at some point in the future.

If and when that happens – nobody knows.

But that’s precisely the reason why you diversify – because we don’t know what the future will bring. You do it to mitigate the risk of the future looking different from the recent past and to help you stick with your overall portfolio in case it does – there’s no other reason.

The only justification for not diversifying today is if you believe there’s been a paradigm shift where large cap U.S. growth outperformance led by the Magnificent Seven will persist forever.

While nothing is impossible, there’s a lot of risk in making that type of concentrated bet if you’re wrong, as we saw in the period from 2000 through 2009. And if you’re right in your belief of continued U.S. exceptionalism, you already have significant exposure to that theme as a passive investor, with 65% of the global equity market now comprised of U.S. stocks.

Disclaimer: All information provided is for educational purposes only and does not constitute investment, legal or tax advice, or an offer to buy or sell any security. Read our full disclosures here.

The post Why You Diversify appeared first on Charlie Bilello’s Blog.