Key Points

  • The recent, decade-plus returns of diversified portfolios have disappointed relative to mainstream US stocks and bonds.

  • A long-term examination, dating back to the mid-1970s, reveals such a shortfall is not unprecedented and the long-term case for diversification is still powerful.

  • Extrapolating the recent superior performance of the 60/40 mix into the future requires the dangerous assumption that US stock market valuations will march to nearly unprecedented levels. Diversification is needed now more than ever.

John West is the corresponding author.

In 1952, Harry Markowitz published “Portfolio Selection” and helped usher in the era of modern portfolio theory. Harry’s work showed us that a portfolio’s risk is not defined by the riskiness of its individual assets, but by the extent the portfolio’s assets’ price movements correlate, or move together. Harry demonstrated that a technique, now known as mean-variance optimization, derives an efficient frontier of portfolios, each of which maximizes expected return at any given level of risk.1 At a Research Affiliates’ forum, Harry told attendees that “the capital markets offer two free lunches: diversification and mean reversion.”

Diversification is a theoretically powerful concept, but as our friend Jason Hsu is fond of saying: “Diversification is a regret-maximizing strategy.” In a roaring bull market, such as 2009–2020 and 1991–1999, we investors regret every penny we put into diversifiers, while in a secular bear market, such as 2000–2009 and 1968–1982, we regret every penny we did not put into diversifiers.

In a rerun of the 1990s, the 2010s were brutal to diversifying strategies. As it was in 1999, the wisdom of diversification is again under attack. The pressure to ignore diversification grew even stronger last year when the COVID-induced bear market of February–March 2020 was no less savage to diversifying asset classes than to 60/40 investors in the US market, and the stimulus-induced rebound again rewarded the “naïve” 60/40 investor for shunning diversification.

We affirm the wisdom expressed in a quote often misattributed to Yogi Berra: “In theory, there is no difference between theory and practice, while in practice there is.”2 In theory, diversification is a “free lunch” for the patient investor. In practice, an investor was substantially better off if she had invested solely in the classic US 60/40 portfolio—60% in the S&P 500 Index and 40% in the investment-grade bond market—at a near-zero management fee over the last dozen years. Diversified investors were far less rewarded for the same level of risk! This outcome has led many advisors and fiduciaries, on the receiving end of complaints from unhappy clients, to abandon diversification.