One of the cornerstones of Modern Portfolio Theory is the concept of diversification, the process of allocating assets among several asset classes as not to “put all your eggs in one basket.” This seeks to reduce overall portfolio risk or volatility by not making significant positions in any one area of the market. In the long run, diversification can be effective as a prudent strategy for most investors. In the short run, however, diversification can work against you.
Let’s take 2023 and 2024, for example. For the most part, one asset class – large cap growth stocks - drove the lion’s share of stock market’s performance. More accurately, there were only seven stocks that produced the vast majority of the S&P 500’s performance. In this scenario, the average investor who believes in diversification most likely underperformed “the market” because they were invested in other areas of the market such as value stocks, mid and small cap stocks, foreign and emerging markets stocks that did not perform nearly as well. The best performing portfolios were those that took concentrated positions in large cap growth stocks – the exact opposite of diversification.
Now look at 2025. While the large cap growth asset class performed relatively well, large cap value stocks did as well. And foreign stocks actually outperformed the U.S. market for the first time in several years. What’s more surprising, foreign emerging market stocks were one of the top performers of 2025, a stark reversal after many years of dismal performance. The point here is that by remaining diversified across several different asset classes, the investor likely captured superior performance in many other areas of the market.
So, what is the investor to do when diversification works in some market environments and not so well in others? Investors cannot expect to be able to consistently make rapid changes in their investments in an attempt to time the market. One technique that has gained in popularity is starting with a broadly diversified portfolio, setting aside a certain percentage, maybe up to 20% of the portfolio, to make what are referred to as “technical tilts” towards certain areas of the market. In 2023 and 2024, this would have involved adding to an already existing allocation to large cap growth stocks. This would have led to an overweight in that one asset class, but nowhere near a concentrated position.
The process of under and overweighting asset classes helps an otherwise diversified portfolio slightly focus on, or away from, specific areas of the market. In practice here is how this would have looked in 2025 – underweight small and mid-cap stocks, overweight large cap growth and value stocks, and overweight foreign and emerging market stocks. Please keep in mind that there is never a guarantee that any particular investment management technique will always be successful. The disciplined investor who never makes portfolio changes based on emotions stands the best chance of long-term success.