• The outperformance of the US equity market in recent years may raise doubts for some investors about global diversification, but there’s a fallacy in that argument.

• The only certainty in investing is that the gains in one part of the market can typically offset the losses in other parts of the market.

• While diversification makes sense in any environment or time period, it may be particularly important now since, by most measures, US stocks are overvalued.

Imagine an equity investor who prudently stayed globally diversified over the years - they may understandably feel buyer’s remorse. After all, a €100 investment in US equities 10 years ago would have grown to €364 by the end of 2024 (an annualised 14% return) - more than twice the final balance of €175 (an annualised 6% return) for an equivalent investment in global ex-US equities¹. The wide performance gap between the two has many investors questioning the benefits of global portfolio diversification.

But with that logic in mind, why stop with global diversification? The same argument could apply to all levels of portfolio diversification. Looking at market results over the 10 years ended 31 December 2024, why bother with broadly diversified US equity exposure when US growth stocks outperformed the broad US market by 1.4 times (€513 versus €364)? Why invest in value stocks at all?

Or given that the information technology sector, in turn, outperformed growth stocks by 1.4 times, why not just concentrate the entire equity portfolio in that sector? And why not further weed out the underperforming parts of the sector? The Magnificent Seven outperformed the IT sector by 6.8 times². And one stock, Nvidia, outperformed the collective return of the Magnificent Seven by 6.3 times. 

You can always find an asset that will outperform your portfolio

Past performance is not a reliable indicator of future results. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

Notes: Charts show the final balance of a hypothetical €100 investment in the relevant MSCI indices and in individual equities denominated in EUR for the 10 years ended 31 December 2024. 

Source: Vanguard calculations, based on MSCI indices and historical equity data from Bloomberg, as at 31 December 2024. Performance calculated in EUR with gross income reinvested.

Taking the past-performance argument to its logical conclusion reveals the argument’s fallacy - you end up with a one-stock portfolio. Instead of Nvidia, what if the investor had bought a once-high-flying stock that ultimately faded into obscurity?

Hedging the unknowable

The idea that one country or region outperforms the others is not a failure of global diversification - on the contrary. Back in 2015, nobody knew for certain which region would do better. The only certainty was that the gains in the part of the market that outperformed could offset the losses in the other parts of the market. And that is exactly what has happened over the last 10 years. 

An investor with a portfolio diversified across US and global ex-US stocks in a 60%/40% ratio would have had returns close to 11% annualised over the past 10 years - respectable returns delivered with considerably less risk than the uncertainty of choosing between an all-US portfolio and an all-non-US portfolio.

To understand how diversification works, let’s consider an investment with 50/50 odds of two possible outcomes: a high return (say 14% annualised, similar to the all-US equity portfolio over the last 10 years) and a lower return (say 6% annualised, similar to the global ex-US equity portfolio). Notice that this is not a bad investment, as even in the worst-case scenario, the return is at least 6%. Moreover, given the 50/50 odds, the expected value of this investment is actually 10% (a 50% chance of a 6% return plus a 50% chance of a 14% return). 

But what if, along with that investment, there is the offer of an insurance policy—the chance to get 10% no matter what? The insurance contract is that you get paid 4% on top of the lower return outcome, but you have to pay 4% to the insurer if you get the high return.

The insurance contract removes the risk of the 50/50 investment. Who wouldn’t take it? Of course, if the outcome is the 14% high return, some investors may regret having added the insurance. But that’s no different than complaining about paying insurance policy premiums after a year of not needing to make a claim. In our view, when offered to play another round of the game, we would stick with the insurance every time.

Of course, this comparison isn’t perfect. Unlike insurance, diversification does not ensure a profit or protect against a loss. But it acts as a hedge against risk, avoiding the extremes. 

Current valuations are vulnerable 

Although diversification makes sense in any environment or time period, it may be particularly important now. By most measures, US equities are overvalued. While non-US markets have also appreciated, Vanguard broadly considers them fairly valued. 

By no means do we predict an imminent market correction. No one can predict the timing or magnitude of a correction, and momentum may continue to carry the day. High valuations are not a market timing tool; instead, they are a useful signal warning us of market risks. Long-term investors would be well-served sticking with portfolio diversification - that is, rebalancing their portfolios back to the diversified mix of assets that is appropriate for their risk profile and goals.

¹ Returns in all the scenarios are based on our calculations using the relevant MSCI indices denominated in EUR over 10 years ended 31 December 2024.

² The Magnificent Seven are the seven stocks that have driven much of the market’s returns over the past few years: Alphabet, Amazon, Apple, Meta Platforms, Microsoft, Nvidia and Tesla.