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Why Diversification Matters More Than Ever

Harry Markowitz, the inventor of modern portfolio theory, famously described diversification as ‘the only free lunch in investing’. Until now, many investors have sought diversification by investing in an index such as the S&P 500, and by maintaining a substantial portion of their portfolio in bonds as a hedge against market volatility.

The S&P 500 has become drastically more top-heavy in recent years. Some estimate that it has never been more concentrated than it is now.

The top ten members of the S&P 500 now account for around 37% of the index. This makes the returns of the index vulnerable to volatility. If the performance of even only the top seven companies were to decline (for example, owing to greater regulatory scrutiny), returns to the index would be disproportionately impacted.

As we move into 2025, there is considerable uncertainty concerning US policies on immigration and tariffs, in addition to geopolitical tensions and the fragmentation of trade.

This combined with concerns over government debt and the specter of stubborn or resurgent inflation means that while traditional assets like public equities and bonds remain core components of many portfolios, their limitations in today’s environment underscore the need to incorporate alternatives to achieve broader diversification and resilience.

Alternatives offer potential opportunities for higher enhanced returns than traditional investments. Particularly, in times like these, they also provide an additional layer of diversification.

Harvard Business School defines alternatives as investments that are not easily sold or quickly converted into cash, unlike traditional investments. While alternatives are relatively illiquid, this longer holding period can shield them from short-term market volatility, allowing investors to take a more strategic, long-term approach to their portfolios.

By virtue of this fact, alternative asset prices are shielded from radical shifts in market sentiment, which can place downward pressure on all stocks in an index, regardless of underlying fundamentals.

While index investing works well during a time of stable growth, volatility requires a more precise and flexible approach, targeting areas of growth and stability. By focusing on specific sub-sectors and companies, whether investing in debt or equity, alternatives provide a means of side-stepping general market malaise.

For example, while trade disruption may be a net negative for the global economy and public markets in the short term, the reconfiguring of supply chains creates ample opportunities for investing outside the stock market (e.g. new storage and manufacturing facilities).

While inflation can have a negative impact on both stocks and bonds, many alternatives can counter the effects of rising prices. For example, real assets, particularly those in areas of inelastic demand such as healthcare, data centers, or critical infrastructure, provide stable income via contracted revenues that are often inflation-protected.

Secular trends such as AI adoption, renewable energy growth, electrified transportation, and demographic-driven needs such as multi-family housing and healthcare, often have the backing of the governments of the country in which they are being built.

Alternatives are a way to adapt to an era of heightened volatility. The fact that they are relatively illiquid and require more effort to locate and appraise is the main reason that many investors have been unwilling or unable to make full use of them in times past.

At the Family Office, we have made it our aim to bring the power of alternative assets within reach for a larger body of investors. By relying on our team’s ability to source and vet appropriate deals, our clients can approach the new year with greater confidence. No matter what the news brings, there is always a path to growth.

Beyond Stocks and Bonds: How Alternatives Strengthen Portfolio Diversification

In this article, we focus on one aspect that has formed the crux of a sea-change in U.S. politics, culminating in re-election of Donald Trump as president. Namely, the perceived abandonment of the semi-skilled, middle-class workforce.

The Trump campaign won a decisive victory in the December elections. In addition to Republican majorities in both houses and a conservative-leaning Supreme Court, Trump also succeeded in securing the popular vote.

On the tide of this victory, Trump has ample support to see through a range of new policies from tariffs to near-shoring and other ‘America First’ initiatives.

Few would also dispute that the former president’s return to the White House has been surrounded by controversy. This controversy extends beyond the U.S. to the global community.

The chart below, based on a poll of 28,549 people across 24 countries, shows a range of opinions. It also shows that it is Western or Western-aligned countries (e.g. South Korea) who take the most pessimistic view of the election outcome.

One potential cause is the perception that the Trump agenda is inherently anti-globalization. Since the end of the Cold War, Western economists (not to mention libertarians and business leaders) have welcomed globalization as a driver of economic growth and prosperity.

Citing Adam Smith’s theories on free trade, which support the free movement of labor and an unobstructed global marketplace, and pointing to the rises in global living standards that have followed the successful implementation of such policies, it is understandable that the return of protectionism and trade wars is seen as a step backward.

Why then does the tide seem to be turning, at least in some quarters?

Lakner and Milanovic’s analysis from 2013, known as the ‘Elephant Curve’, provides a starting point for discussion.

 In a sentence, it shows that globalization has benefited almost everyone but the ‘middle class’, who have seen incomes grow much slower and even decline in some cases.

The trough on the right-hand side, which reaches its lowest point in the 80th percentile of global income, includes the semi-skilled labor class in Western economies (e.g. manufacturing, automotive, electronics), many of whose jobs have been transferred to emerging markets. 

Meanwhile, those at the very top of the global economic hierarchy benefited from the higher profitability of a more cost-efficient labor force,

 deepening the sense that the domestic labor force had been abandoned as the wealth gap widened.

In 1914, Henry Ford paid his workers $5 per day, which amounted to $30 per week (for a six-day workweek)

, this is the equivalent of $4,038 per week or $209,991 per year.

In other words, earnings that are now possible only for highly qualified professionals (e.g. law, accounting, medicine)

, were once standard for semi-skilled factory workers.

The plight of the Western lower-middle class is not an illusion. Addressing it will be the task of governments for decades to come. Meanwhile, the wealth gap is one of various factors giving rise to extreme political ideologies, both on the right and left, exacerbating the problem further.

In the meantime, it is possible for individuals to take their destiny into their own hands. Technology and financial markets have moved on considerably since the days of Henry Ford. Even those from whom wages are the primary source of income can invest capital in the world economy more freely than a century ago.

Not only this, avenues of investing that were previously open only to the ultra-wealthy are also more accessible. One of our main goals at The Family Office is to offer our clients opportunities in formerly exclusive domains (such as private equity and other alternative investments), thus bringing the upper end of the opportunity curve within reach.

Just as a society with greater participation in growth is more stable, a financial future with more options for growth is a brighter one.

 The gold price fluctuates considerably over time and this example should be viewed as illustrative rather than definitive. Directionally, it is intended to show that manufacturing workers had higher earning power than they do today.

The Elephant in the Room: Globalization’s Uneven Gains

Recently published minutes show that the Federal reserve (the “Fed”) had less confidence than in prior months. While there was only one dissenting vote, many officials appear to have been in two minds about whether to leave rates as they were.

The final decision was, to quote the minutes themselves ‘finely balanced’.

Why the hesitation? Chiefly, two factors:

Markets were somewhat shaken, not by the interest rate decision itself, which was expected and largely welcomed, but by the noticeable change in outlook in the Fed’s revised projections for the coming year.

While optimistic about economic growth and employment, the projections showed inflation would remain higher for longer, not reaching the target 2% level until 2027. Accordingly, only two rate cuts are forecast in 2025, compared to the four predicted in the previous projections.

The overall impression is less one of gloom than of uncertainty. As Chairman Jerome Powell put it in the press conference, “It’s not unlike driving on a foggy night or walking into a dark room of furniture. You just slow down.”

This may seem like a sudden shift. Until recently, the news headlines were portraying the inflation figures as on a positive trajectory. This is true if we consider the progress made since the high point of 2022.

Personal Consumption Expenditures (PCI), Percent Change from Year Ago, Monthly, Seasonally Adjusted

However, if we zoom-in on 2024 specifically, we can see an apparent reversal beginning (awaiting trend confirmation) in the final months of the year.

In September 2024, when the Fed made its first 50 bps cut, PCE inflation was at 2.1%, barely a whisker off the long-sought target. In November it had risen back to 2.4%, with Core PCE (that is, excluding food and energy) even higher at 2.8%.

Meanwhile, the president-elect Donald Trump and his team have so far hinted at a wide range of policies, some of which could lead to higher inflation.

 For example, restricting immigration could put upward pressure on wages, and higher tariffs could lead directly and indirectly to price increases for consumer goods.

Recent statements made by Fed officials appear to show they are still divided in opinion. Fed governor Christopher Waller expressed optimism that inflation will go down regardless of any tariffs introduced.

Colleagues such as Fed Governor Michelle Bowman have been more forthright in highlighting the threat of inflation and the resilience of the labor market.

Beth Hammack, the sole dissenter in the December 2024 meeting, observed in a speech earlier that month that “Some of the forces that appeared to be holding down the neutral rate following the Global Financial Crisis may have finally run their course or reversed”.

Kansas City Fed President Jeff Schmid added his view that rates may be “very close to their longer-run level now”.

 If true, this could imply that rates are set to remain around 4% for the medium term, as opposed to the 3% the Fed is officially projecting.

The markets themselves are predicting little change in 2025, with a majority (72%) pricing in only one rate cut or none at all.

The upshot is that no one can tell what path interest rates will take. If unemployment worsens substantially, rate cuts may become a necessity. If inflation resurges and the economy remains strong, rates could in theory begin to rise again.

As usual, we at The Family Office prefer to avoid prediction and instead look more closely at the fundamentals. If Hammack is correct, and these fundamentals are shifting, we have no choice but to embrace uncertainty, stay diversified, and remain skeptical of sweeping predictions and misleading consensus.

On A Knife’s Edge: The Fed's First Move in 2025

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