By Andrew Welsch

If investors needed a reminder that diversification is the only free lunch in investing, they're getting it this year. U.S. stocks have been hammered on concerns about tariffs and weakening economic growth. International stocks have risen this year.

The Vanguard Total Stock Market Index Fund ETF is down 7.05%. Large-cap growth stocks and the Magnificent Seven have been hit particularly hard.

In contrast, the Vanguard FTSE All-World ex-US ETF is up 7.92%. European stocks have done even better, with Vanguard FTSE Europe ETF up 14.2%. All three are broad-based index funds.

That's quite the reversal from recent years when large-cap U.S. stocks outperformed their overseas counterparts, sometimes by significant margins.

Bonds, the traditional stock diversifier, have been poor performers for the past three years. The iShares Core US Aggregate Bond ETF, which tracks a broad benchmark of U.S. bonds, has a three-year total return of just 1.5% after losing 12% in 2022. That experience may have tempted some investors to throw in the towel on asset classes other than large-cap U.S. stocks.

"Diversification can sometimes be hard because by its nature you're underperforming on some asset," says Matt Boersen, managing partner at Straight Path Wealth Management in Jenison, Mich. "If you were diversified then by definition you were underperforming the S&P 500, which is what most people look at."

But, as advisors often explain to clients, having a diversified portfolio means you avoid having all your eggs in one basket -- and you mitigate risks. Having a diversified portfolio coming into 2025 would have blunted the pain of sharp declines in U.S. stocks.

Rob Williams, managing director of financial planning at Charles Schwab, illustrates the benefits of diversification this year using his company's model portfolios. The S&P 500 was down 8.2% year to date as of April 23. Its maximum decline earlier in April was 18.7%. Schwab's aggressive model portfolio, which is roughly 95% U.S. and international equities and 5% cash, was down just 4.5% as of April 23. Its maximum decline was 16.1%.

Schwab's moderate allocation model portfolio (5% cash, 35% bonds, and the rest U.S. and international stocks) is down a more modest 2.2% as of April 23. And its maximum drawdown was 10%.

"Depending on the time horizon and your risk tolerance, diversification can smooth out the ride through periods of market and emotional stress," Williams says.

Financial advisors say the right mix varies depending on a client's goals, time horizon, and risk tolerance. The objective is to create a portfolio of assets that aren't all correlated with one another, i.e. you want some to zig when others zag. That can result in better risk-adjusted returns over time and help protect your wealth.

"Concentration is how you make your wealth," says Charles Day, a UBS financial advisor who is also ranked among Barron's Top 1,200 Advisors for 2025. "By and large, people who are extremely wealthy hit it big on a stock, or they sold their company. But diversification preserves your money. You don't hit home runs with diversification, but you avoid disaster."

Relationships change. Correlations between different assets can change over time. As research company Morningstar notes in a new report, the correlation between international and U.S. stocks is higher than it once was, but that may easily change again. The dollar could lose its value or the U.S. could fall into a tariff-induced recession while other countries don't. Non-U.S. stocks don't always move in lockstep with the U.S. market, Morningstar's report finds. The period between the dot-com bust and the financial crisis was a rough one for large-cap U.S. stocks, but better for international equities.

"There are time periods when certain asset classes or markets perform better, and then it flips," Boersen says. "Sometimes those cyclical periods can last for a while. You may feel like you want to time it, but the academic research is clear that that is very hard to do."

Alternative investments, such as private-equity funds, may add diversification benefits. But because of their fees and illiquidity, they may be better suited to ultrahigh-net-worth investors.

The Morningstar report suggests investors looking for diversification need not stray from a mix of stocks and bonds. "Not every asset type with a low correlation coefficient is worth adding to a diversified portfolio," the report says. "For example, cryptocurrency's extreme volatility makes it difficult to live with, while private investments' inherent lack of liquidity makes them impractical for investors planning to fund a goal at a specific point in time."

Don't wait. Today, investors with underdiversified portfolios may be wishing they had increased their allocation to international stocks in December.

"Down markets are a good measure of our tolerance for risk," says Schwab's Williams. "If you find yourself panicking, stressed and tempted to sell when the market turns negative, that's usually a good indication that you might want to review your asset allocation."

It isn't too late to begin shifting portfolio allocations. In fact, asset manager Vanguard expects U.S. equities to average 4.4% to 6.4% annual returns over the next decade compared with 6.2% to 8.2% for international stocks.

Just don't make dramatic portfolio moves right away, suggests Day, the UBS advisor. He suggests taking an incremental approach. "Think about where your portfolio should be and get in range of that within a year," he says.

That may mean slowly moving more assets into international equities if you're overweight U.S. stocks. Or it may mean upping your bond allocation if the stock market's gyrations are causing stress. "Eat your broccoli," Day says. "Buy the stuff you don't like but that you know is good for you."

For investors, this year has been full of surprises and upsets. With appropriate diversification, your portfolio can be one less thing to worry about.

Write to Andrew Welsch at andrew.welsch@barrons.com

This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.

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April 28, 2025 13:57 ET (17:57 GMT)

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