Evidence-Based Investment Insights: Diversifying for a Smoother Ride
Learn how diversification can help manage portfolio volatility, reduce concentration risk, and support a more disciplined long-term investment approach.
In our last piece, “Diversifying for A Smoother Ride,” we wrapped up a discussion about the benefits of diversified investing. The next step is to understand how to build your own diversified portfolio to participate in long-term global market returns in a way that reflects your willingness, ability and need to take on investment risks.
This in turn calls for understanding why we can expect investment returns to begin with.
With all the excitement over the market’s ups and downs in headline news, there is a key concept often overlooked:
Market returns can be thought of as compensation for providing financial capital to a world of human enterprise going on all around us, all the time.
For example, when you buy a stock or a bond, your capital is ultimately put to work by real-life businesses or agencies. Each of them expects to succeed at whatever it is doing, whether that is growing oranges, operating a municipality or flying us to Mars. You, in turn, are investing that capital with the expectation of earning a return, while recognizing that investment outcomes are never guaranteed.
A company hopes to generate profits. A government agency hopes to complete its work within its available resources. Investors hope to earn returns on the capital they provide. You might think that when a company or agency succeeds, its investors necessarily will, too. But operational success is only one factor among many that influence investment returns.
This may seem counterintuitive. For example, even if a business is booming, you cannot necessarily expect to reap the rewards simply by buying stock in it. Strong operating results and expectations for future growth may already be reflected in the price investors are being asked to pay. As we have covered before, widely available good or bad news can be incorporated rapidly into current market prices.
So, what does drive expected returns? There are a number of factors involved, but some of the most important spring from the unavoidable investment risks we introduced earlier. Markets generally require higher expected returns as compensation for bearing certain risks that cannot simply be diversified away.
Consider two of the broadest asset classes: stocks (equities) and bonds (fixed income). One of the most fundamental portfolio decisions is determining how much exposure to allocate to each. So why does that allocation matter?
When you buy a bond…
When you buy a stock…
Because equity investors generally accept greater uncertainty and stand behind creditors in the capital structure, they typically require a higher expected return than bond investors in the same issuer.
This difference is reflected in what is known as the equity risk premium: the historical or expected excess return of equities over fixed-income investments such as bonds or Treasury bills.
Long-term market history helps illustrate the relationship between risk and return. CFA Institute Research Foundation’s 2026 review of U.S. markets found that from 1926 through 2025, $1 invested in U.S. large-cap stocks grew to $14,751, compared with $117 invested in long-term Treasury bonds. That greater long-term equity growth came with substantially greater volatility and periods of significant loss along the way. Past performance, of course, does not guarantee future results.
The precise amount of the equity risk premium—and how long it may take to appear—is never a sure thing. Estimates vary, market conditions change and realized returns may differ considerably from expectations.
It is also important to remember that “stocks versus bonds” is an intentionally broad comparison. Credit quality, maturity, interest-rate sensitivity and other characteristics can materially affect the risk of individual bonds. A lower-quality bond, for example, can carry substantial credit risk.
Still, history illustrates two important characteristics of equities: over very long periods, stocks have delivered higher returns than high-quality bonds, while also subjecting investors to substantially greater volatility along the way.
Exposure to stock market risk has long been one of the most widely recognized sources of expected return. Academic research also points to additional systematic factors that may contribute to differences in expected returns.
Next up in our series, we will continue to explore market factors and expected returns, and why an evidence-based approach is so important to that discussion.
This post was written and first distributed by The Writing Company.
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This material is intended for general public use. By providing this material, we are not undertaking to provide investment advice for any specific individual or situation, or to otherwise act in a fiduciary capacity. Please contact one of our financial professionals for guidance and information specific to your individual situation. This is not an offer to buy or sell a security.
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