Q I am frustrated. I was told to diversify my holdings using index funds, so I did. I was told to put part of my investments in foreign stocks, so I did that too. They told me diversification would protect me in bad markets, but my diversified portfolio still took a big hit during the COVID meltdown in 2020, and again in 2022, when stocks and bonds plunged. This year, the S&P 500 index is up almost 20 percent, but my diversified portfolio is up only 14 percent. If diversification is so great, why isn’t it working for me?

A You’re asking the same question many professionals started asking 16 years ago in the depths of the financial crisis. At that time, most asset classes dropped in unison, begging the question: if all asset classes fall together, why diversify? This came up again in 2020 with COVID, as well as in 2022 when the Federal Reserve started to aggressively tighten monetary policy. I’m not sure I have all the answers for this important question, but I do have a couple of thoughts.

First, we shouldn’t be surprised that all financial assets dropped when the integrity of the financial markets was threatened. Both the 2008 financial crisis and the COVID shutdown brought us closer to an economic meltdown than we have been since the 1930s. Hard assets like precious metals are a much better hedge in that kind of scenario.

Second, diversification is a tried-and-true strategy for dealing with day-to-day risk management — and not just with investments. Remember the old saying about not putting all your eggs in one basket? Portfolio diversification works the same way. By spreading our risk among many different investments, we protect ourselves and our wealth from the uncertainties of the market.

While diversification can lower portfolio risk, it can also carry a cost in terms of lower returns. Over the past decade, the S&P 500 stock market index produced an average annual total return of about 13 percent, while a well-diversified portfolio returned only seven percent. Based on these numbers, one could argue that diversification cost the diversified investor about 6 percent per year. Perhaps that’s why you feel frustrated.

Looking at a different time interval could lead you to a very different conclusion. For example, between 2002 and 2007, the S&P 500 gained 6.5 percent per year, while the diversified portfolio returned 11 percent. In that case, diversification added 4.5 percent to annual performance.

I don’t worry too much about the cost of diversification. One way to think about the cost of diversification is to think of it as the cost of uncertainty. If you knew with certainty how a particular asset class would perform, you wouldn’t need to diversify your portfolio. However, since we can’t know future returns with certainty, diversification is the better option.

QWhen I diversify my portfolio, how do I decide how much to place in different kinds of investments?

ASeveral years ago, Harry Markowitz published an essay that tried to answer this question. His approach, known as Modern Portfolio Theory, or MPT, changed the world of finance and eventually won Markowitz the Nobel Prize in economics.

MPT says investors can select a mix of asset classes which will reflect the highest expected return for a given level of portfolio risk. In MPT, the primary risk in question is portfolio variance, or the degree to which a portfolio’s actual value fluctuates around its expected value. The greater the variance, the greater the risk. The more risk a portfolio has, the greater the portfolio’s expected return must be. In fact, under MPT, a portfolio’s expected return is a function of the portfolio’s risk. If you want to learn more about Modern Portfolio Theory, check out Investopedia.com’s entry on the subject.

If you’re wondering how diversified your portfolio is, there are some excellent online tools for this, many of which are anchored in Modern Portfolio Theory. A quick and easy tool is located at https://www.portfoliovisualizer.com/efficient-frontier. Simply enter your portfolio’s asset allocation and the minimum and maximum percentages you allow in each asset class. The app will plot the risk and expected return of your current portfolio, while suggesting an alternate portfolio allocation for the same level of risk.

Steven C. Merrell is a partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to smerrell@montereypw.com.