Diversification: Why Losing in the Short Term Helps You Win in the Long Term 

Diversification is good but requires good behavior

By Bob Peters || July 12, 2025

Long-term wealth accumulation comes down to a simple formula: invest as early as possible, contribute regularly, and stick with a sound investment plan. Of those three, sticking to the plan is often the hardest-thanks to two powerful forces: one genetic and one environmental. 

The genetic factor is our built-in “fight-or-flight” response, the same one that once helped our ancestors avoid predators on the Serengeti. The environmental factor is our learned tendency to fix problems when things don’t appear to be working. And that’s exactly why losing in the short term can set the stage for winning in the long term. 

A Real Conversation: Meet Lima 

I wrote this post after a recent conversation with a thirty-something I’ll call Lima. About six years ago, Lima graduated from college and began his career. At the time, we discussed his 401(k) options, and he chose a simple, diversified approach: roughly one-third in the broad U.S. equity market, one-third in small-cap U.S. value stocks, and one-third in international equities. 

He contributed regularly and kept an eye on performance. But over time, his once-balanced allocation became skewed: about 66% ended up in the total U.S. market, 23% in international stocks, and only 11% in small-cap U.S. value. 

His reaction? Shift everything into the U.S. total market fund-the one that appeared to be “winning.” Why? Because the other two seemed to be underperforming. His instincts told him to act: avoid the “losers” and double down on the “winner.” In evolutionary terms, the lion was approaching, and his brain kicked into survival mode. 

Diversification Improves Long-Term Returns 

We’ve previously highlighted the foundational research behind diversification. The 1990 Nobel Prize winners-Harry Markowitz, Merton Miller, and William Sharpe-demonstrated how combining uncorrelated assets can improve risk-adjusted returns. Hendrik Bessembinder’s research added another dimension, showing that a tiny percentage of stocks are responsible for the majority of long-term market gains.

The takeaway? It’s extraordinarily unlikely that you-or even a professional-will consistently beat the market by picking winners. Broad diversification gives you the best odds of capturing those rare, high-performing investments.

So Why Is It So Hard?

Nearly every reputable financial advisor agrees: diversification is a good thing. But the challenge comes in execution. Diversification means you will always own something that isn’t performing well in the short term. And that feels wrong. It feels like you’re making a mistake. 

Our instincts scream at us to fix the “problem.” But in investing, those instincts can lead us astray. 

Back to Lima 

So back to Lima and our recent chat. His instinct was to ditch the underperformers and consolidate into what had been winning lately. That makes perfect sense from a behavioral standpoint. 

But what if, instead of giving in to short-term performance chasing, Lima leaned into the logic of diversification? What if he had rebalanced-sold some of the outperforming U.S. total market fund and “trued up” his allocation so each bucket was back to one-third? 

That takes conviction. It requires not just an understanding of asset allocation and portfolio theory, but also self-awareness-knowing that our genetic wiring and learned behaviors often push us in the wrong direction. 

As Simba famously said in The Lion King, “I laugh in the face of danger.” Can you? 

What Would I Do? 

If I were 30 again, and knew what I know now, I’d rebalance back to one-third in each category-U.S. broad market, international, and small-cap value (assuming no tax liability). I’d do so fully aware that in 1, 6, or 12 months, two of the three are likely to underperform. And in 6 years, the disparity could be even greater. 

But I’d continue contributing to all three with confidence, knowing that diversification and compounding would be my allies when I truly needed them-20 or 30 years down the road. 

What Should You Do? 

I can’t answer that directly. I don’t know your personal circumstances, and I’m not offering individualized investment advice. Plus, there are regulations that prevent me from doing so. 

But here’s what I can tell you: your behavior matters more than any one investment decision. You can keep it simple. The real magic lies in consistency-investing regularly, understanding the interplay between human and financial capital, sticking to a plan, and managing your emotions. 

You’ve got this. 

And yes-when the market gets scary and your instincts shout at you to run-I hope you’ll channel your inner Simba. 

“I laugh in the face of danger… Ha, ha, ha!”