Why diversification only gets noticed when markets get noisy

In this article, our special contributor and Daily Telegraph investment columnist David Stevenson explores straightforward strategies to manage market volatility, with a focus on asset allocation and diversification.  

Market turbulence, otherwise known as volatility, spooks investors. It’s reasonable to see, say, gold prices plunging and then panic as you scan down the list of gold stocks you own and think, “Sell!”. But in this article, I’m going to try to reassure you that volatility is normal, that it can be managed, and that simple, straightforward strategies can be enormously useful. 

We’ll encounter lots of complicated and technical-sounding terms like asset allocation and geographical and style diversification, but the message isn’t that complicated – simple ideas and methodologies can make you a better investor. 

Let’s start with the first key point financial markets, whether for equities or bonds, can be volatile, but that turbulence usually lasts only a short period. The data to back this up comes from numerous studies tracking the VIX index, also known as the Fear Gauge. The VIX index tracks the daily ups and downs of the world’s biggest, most liquid market, US equities, and the S&P 500. The Vix index has only been around since 1993, but academic economists have looked back to before 1993 to piece together a picture of how stock markets respond to sudden shocks and panics. 

A rough-and-ready reckoner is that if the Vix index is above 30, it’s turbulent; the average is around 20, and the markets are calm when it’s around 15 or less. So what’s the bottom line on these volatility spikes? On average, it takes approximately 20 trading days (roughly one month) for the VIX to revert to its mean after a significant shock. 

However, this mean reversion varies significantly depending on the market regime and the severity of the spike. Some spikes can last longer consider the global financial crisis of 2008-09. This was the longest period of elevated volatility. The VIX stayed above its “calm” level of 20 for 331 consecutive trading days (August 2008 to December 2009). By contrast, the Covid spike in 2020 was a “fast” cycle. The VIX hit a record high of 82.69 in March but reverted to the 20s within roughly 60 trading days, much faster than the 2008 recovery. 

So, the message on volatility is simple unless we are in a major shock, you should expect stock markets to calm down after a month in most cases, though it can last for months if we’re in a real mess.

And it’s not just stocks and shares that have turbulent patches. Many bond investors watch something called the MOVE Index, which measures the implied volatility of US Treasury options across the yield curve. Over the past 30 years (since its inception in the late 1980s), the MOVE index has generally fluctuated between 80 and 90 but has dropped as low as 40 and reached highs of 160 to 260 during the global financial crisis. And remember, bonds are supposed to be less risky and less volatile than equities. And yet, even with this range of values, the MOVE index reverts very quickly and spends much of its time chugging along around the average. 

So, volatility is real in all financial assets and can make a difference, but it’s usually only temporary. But temporary doesn’t mean it can’t be painful. The good news is that there are various ways of managing this – these methods range from simple behavioural strategies, such as constantly buying into the market and not timing it, to more complex strategies focused on asset allocation and diversification. Let’s take each bundle of strategies in turn and start with simple behaviour switches.

Behave like a smarter investor

One idea is to segregate how you handle risk in your investments. This involves accepting that there is a riskier pocket of money; let’s call it the satellite portfolio. In this bundle of assets (stocks, probably), you do riskier stuff like invest in major themes or trends. This satellite approach is reflected in the growth of thematic ETFs active and thematic ETFs (Artificial Intelligence, Clean Energy, Crypto) have seen a 39% year-on-year increase. These are almost exclusively used as “satellites” to provide “kick” to a portfolio without replacing the core portfolio.

In that larger core portfolio, you may have a managed fund option or find an asset allocation (see later) that fits your long-term goals. In this core, you might, for instance, invest in low-cost index trackers that track major benchmarks such as the S&P 500 or the MSCI World. Crucially, in the core, you might adopt a ‘no look’ policy of not checking in every day on performance – you just leave alone, ignore market volatility and get on with the boring work of compounding returns. 

By contrast, in your satellite portfolio, you might be more attentive, and you might even embrace volatility – as one active fund manager once told me, “David, volatility can be your friend if you’ve done your research and you can buy an attractive stock cheaply because others panic”. 

Another strategy based on sensible behaviour is to pound cost average, i.e., just keep investing a regular sum every month/week/quarter and ignore the ups and downs of the market, be that for bonds or equities. This would probably suit the core portfolio very well, but can be applied across all your investments.

I’m frequently asked by investors who come into a lump sum what to do, and my message is simple try to slowly but steadily feed that capital into the market while avoiding taking a call on the market’s direction. Timing the market is a nightmarish task, and although not impossible, is fraught with danger. A large body of academic research has examined three common strategies pound-cost averaging, buying the dip and investing a lump sum, and nearly all of them suggest that pound cost averaging is the safer strategy, although lump sum investing can outperform if you time it perfectly, which you probably won’t. The beauty of dollar-cost averaging is that it forces you to buy the dip without having to be “brave.” 

Asset allocation 101

So, good behaviours can make a difference and help you manage risk, but the most powerful tool is asset allocation. It’s what wealth managers and fund managers do all the time, and it works, by and large. 

Asset allocation theory is built on the central concept of diversifying among assets, such as bonds, equities, and alternatives such as precious metals – all of which behave in different ways. There’s a huge amount of literature on this subject, but the most cited is something called the 90% rule, which comes from a landmark study by Brinson, Hood, and Beebower. This found that approximately 90% of the variation in a portfolio’s returns over time is explained by its asset allocation (how much you put in stocks vs. bonds vs. cash), rather than individual stock picking or market timing. Or put it more simply it’s more important to decide that you are in various markets rather than which specific stock you buy.

This study is supported by analyses from major fund managers in their annual “heatmap” charts, which show asset class returns. These heatmaps, in a compelling visual style, demonstrate that over the last 20 years, no single asset class has stayed at the top for long. By contrast, although a diversified portfolio of asset classes rarely ranks first in any single year, it almost never ranks at the bottom. Over 20 years, the compounded return of a diversified portfolio often beats a “market timer” who moves their money to last year’s winner.

The bottom line on asset allocation? Data from the last 20 years (2006–2026) suggests that while asset allocation might not always maximise your maximum possible return, it consistently maximises your risk-adjusted return (the amount of return you get for the stress you endure).

So what might a sensible asset allocation look like? 

One very easy way to explain what it might look like is the legendary 60/40 portfolio, beloved not only of many wealth managers but also by many private investors. In simple terms, you put 60% into equities and 40% into bonds. That’s it, though obviously it can be more complicated than that.

Nevertheless, academic evidence suggests that over the last 30 years (1996–2026), the 60/40 portfolio has provided stable returns. While it rarely beats a 100% equity portfolio during rampant bull markets, it has historically captured about 80% of the gains with only about 60% of the volatility. For instance, during the dot-com crash and the global financial crisis, 100% equity investors saw their portfolios cut nearly in half. 60/40 investors saw significantly smaller drawdowns, which often prevented them from “panic selling” at the bottom. 

One crucial point, though – 60/40 doesn’t always work mechanically every year. It didn’t in 2022, and in some recent years it has failed compared with a simple strategy of investing only in tech-focused US equities. But if you look at the last 30 years (since 1996), a 60/40 portfolio has outperformed a simple 100% global equities portfolio in at least 9 of those years and, in most of the other years, has not been too far behind in total return terms, while offering lower volatility. To be more precise, if you’d have invested £10,000 in 1996, thirty years later a 100% global equities portfolio (MSCI World dollar) would have given you an annualised return of around 9% per annum. By contrast, a 60/40 portfolio would have returned 7.2% but with much lower single-year drawdowns and markedly lower volatility. 

The 60/40 portfolio might not make sense for many investors, especially younger investors who can afford to ignore risk and go all in on equities, but it does work for many older, more cautious investors. But asset allocation and the benefits of diversification can be applied in lots of different ways – geographical and style diversification can be as useful as a 60/40 strategy. 

Let’s take a concrete, current example US equities. You might have noticed that the US equity market accounts for 60-75% of most global equity benchmarks, depending on the index. Annoyingly, a magnificent 7 dominate that US equity market – something around 30% of the US S&P 500 index. I say annoyingly because although investors in the Mag 7 have made a huge profit in recent years, there is a real concentration risk, i.e., the Mag7 or more pertinently, just Nvidia and Alphabet might stumble. So, your asset allocation could be 100% equities, but you still feel you need some sensible diversification. What to do?

One option is not to worry and simply hand over your core portfolio to a managed fund solution where someone else does the asset allocation for you. Alternatively, you could invest in different underlying benchmarks or funds in the US and globally. In the US, you might weigh your exposure to mid-cap stocks in the S&P 400 or small caps in the Russell 2000. 

Or you could try geographic diversification, i.e., downweighting the US exposure and upweighting the Rest of the World (RoW) markets. After the pandemic, the RoW focus underperformed US equities but outperformed them in 2025, and the RoW strategy also outperformed during 2002-2007. 

Geographic diversification is probably worth thinking about at the moment because of the extreme concentration of US tech equities, but it’s not the only diversification you can think of in asset allocation terms. There’s also what we call style or factor diversification. This can sound foreboding, but it’s not that complicated in actuality. 

If we look at the stock market, there are different types of stocks many are momentum- or growth-oriented, such as tech stocks. But there are also cheaper, less exciting stocks, also known as value stocks. Then there are quality stocks that aren’t necessarily cheap but have solid business models and great finances. 

Last but by no means least, there are low-volatility stocks, i.e., stocks that don’t move up and down much. Helpfully, the global equities benchmark, the MSCI World, breaks down these types or styles of stocks into different indices, and you can see the results below. It won’t come as a great surprise to find that momentum has by and large been the top dog, but history teaches us that when momentum falters, the other styles tend to outperform. Diversification across different stock styles might make sense.

If all this talk of asset allocation sounds a little daunting, then go with a managed funds solution – that way, you’ll have a manager do all the hard work of asset allocation for you. But I do want to finish with one last point you, the private investor and your skill set.

Private investors and their foibles

In my humble opinion, private investors aren’t actually as terrible as many finance professionals make them out to be. There is a long history of rubbishing private investors as momentum-seeking, short-termists. That said, there is also a body of academic literature showing that private investors certainly have their foibles. 

Take two pieces of evidence, first the Dalbar “Quantitative Analysis of Investor Behaviour” (QAIB) study, which has tracked US private investors for over 30 years. This suggests that while the S&P 500 might return 9-10% over a 20-year period, the average equity mutual fund investor often earns only 5-6%. The underperformance isn’t necessarily due to the funds being bad, but rather because private investors often buy and sell at the wrong time. They tend to “buy high” (pouring money in during a bull market) and “sell low” (panicking during a crash).

There are also the seminal Barber & Odean studies, which highlight specific reasons why private investors struggle compared to professionals over-trading, information asymmetry, and performance chasing. 

But professional fund managers aren’t always geniuses either. Index firm S&P Dow Jones Indices releases an annual “SPIVA” report comparing active fund managers against benchmarks. This consistently shows that, over a 15-year period, around 90% of professional active managers fail to beat their benchmarks (such as the S&P 500). 

All these studies show that professional fund managers are generally better than the average private investor at staying the course and managing risk, but they are still statistically unlikely to beat a simple, low-cost index fund after their fees are deducted.

I’d summarise the research as follows private investors aren’t obviously “worse” at picking stocks; they are “worse” at managing their own emotions. They are also inclined to time their market investments, a strategy doomed to fail. 

But by managing their behaviour, minimising their fear of volatility, and building on good investor behaviours, private investors can massively improve their odds of producing sustained returns. Add in the overlay of sensible Asset Allocation and diversification, and you have the makings of a decent long-term strategy for wealth creation. 

Please remember that when investing, your capital is at risk. The value of your portfolio with Moneyfarm can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future performance. The views expressed here should not be taken as a recommendation, advice or forecast. Investing is usually for the long term, but it depends on the circumstances of each individual. If you are unsure investing is the right choice for you, please seek financial advice.