A Year Tailor Made for Diversification
The fourth quarter of 2025 was perhaps not exceptional in its own right but nonetheless managed to put a small exclamation point on the end of a phenomenal year for investors. The early-year correction is but a distant memory (yes, that was 2025), as US equities continued to shine in 2025. But diversifying assets like Developed and Emerging International managed to shine brighter, and none were as luminous as Gold.
The Fed cut rates a third time in December 2025
A third rate cut was expected in December and the Fed delivered, cutting the target rate to a range of 3.75-4.00%. While the cut was expected, it was not a certainty given that the last reading on inflation was still above the Fed’s preferred level of 2%. Inflation has been hovering around 3%, but the current picture is clouded by government shutdown which has left a void of recent data.
In the end, it was employment, not inflation, which was the deciding factor for the Fed governors. Employment data has generally been weakening, and the Fed was willing to risk putting upward pressure on inflation to not get behind on the curve on employment.
The impact of the cuts, along with expectations of more dovish Fed leadership in 2026, was felt in the investment markets. Rate sensitive market segments, like Value stocks and Biotech, outperformed in the second half of the year. In addition, yields fell on bonds and Treasuries (more on that below).
Chart 1: Rate cuts continue despite inflation uncertainty
Source: The US Federal Reserve, Bureau of Economic Analysis
Rate cuts pushed yields lower, making short-term less attractive
The flat yield curve that we began the year with steepened as the Fed’s rate cuts dragged down shorter-term yields. Treasury money market funds, which not too long ago were yielding over 5%, are now closer to 3.5%. As we discussed above, additional cuts are forecast and therefore short-term yields will likely continue to fall. For holders of short-term instruments like government money market funds, those rate cuts will be felt immediately in the form of lower income.
As a result, it is increasingly important to have exposure to higher-yielding instruments further out on the yield curve. Not only do these higher duration instruments generally produce more income, they also have the potential to benefit more from any price move. As the yield curve shifts down, higher duration instruments benefit more in the form of market price increases.
Chart 2: Treasury yields fell and the curve steepened
Source: US Treasury Yields, Factset (as at 12/17/25)
AI-driven speculation continues to drive US Large Cap equities, leading to “bubble” talk
There is increasing rumblings about whether or not the US market is in a bubble. High valuations are only indication of a bubble if future profitability fails to meet today’s high expectations. We can speculate about “is it, or is it not,” but only time will tell if this is an AI bubble, or an AI-driven super-cycle of growth, corporate profitability and productivity.
Either way, it is worth remembering that markets can remain “expensive” for extended periods. Recall that Alan Greenspan famously coined “irrational exuberance” in 1996, well before the 2000 peak of the dot-com bubble.
We do not see it as useful to speculate about a potential bubble and particularly about and timing of its end (whether bursting or deflating). Instead, we prepare by ensuring we have exposure to pockets of relative value. While US Large Cap equities trade at a 63% premium to last year’s earnings, other market segments, like Small Cap, have more reasonable valuations, and should be included in a well-diversified portfolio.
Chart 3: US Large Cap is uniquely high priced
Source: LTM PE of S&P500 Index, S&P500 Eq Wgt Index, S&P600 SC Index, MSCI EAFE, MSCI EM (12/28/25)
A well-diversified portfolio likely celebrated in 2025
Diversification is said to be the one free lunch in investing. And it is. Yet, it is often said that diversification can feel like you’re losing, even when you are winning. Here’s why:
- Investors with diversified portfolios can feel like they are losing in a negative return year even when they outperform, because negative returns feel bad :(
- When equity markets take off, a well-diversified, less-risky portfolio will often lag, resulting once again in a disappointing feeling :(
- Yet, over time, diversified portfolios have the potential to provide the one free lunch in investing… less risk, for the same return :)
In some ways, this year broke all the rules. US equities had an exceptional year, with the S&P 500 producing a total return just shy of 18%. Yet some diversifiers that we would typically include in our strategies outperformed. Gold was most notable, up almost 70%. But other standouts included International funds (both developed and emerging) which were up over 30% and Biotech, which after a few rough years, was also up over 30%. Small cap stocks ended the year strong but lagged by a few percent overall.
Chart 4: Diversification worked
* Does not represent any portfolio managed by Strategic
A great year for US Equities; even better for Gold and International
We touched on some of it above, but we always like to wrap up our review of the year with a look at the winners and losers on the year. With all assets in positive territory, “loser” is purely relative.
- US Large Cap stocks produced a total return of 19% on the year. In most years, that would be a headline-warranting performance. But Gold and International are the true standouts for 2025.
- Gold finished the year where it started; exceptional. A weak dollar, rate cuts, global central bank buying, high equity valuations, and its continued perception as a store of value in uncertain times drove demand.
- International stocks (both developed and emerging) outperformed domestic stocks, helped by better valuations and nearly 10% weaker US dollar.
- US bond returns are at the bottom of the chart, but still notably positive, benefiting from elevated income along with positive price returns from falling yields.
- The US Biotech sector (not shown) was a star amongst equities, benefiting from M&A as well as a lower interest rates.
Chart 5: Full Year 2025 asset class roundup
Source: Factset
“Diversification is the only free lunch in investing.” — Harry Markowitz
As we enter a new year, the euphoria of last year’s gains sit in the shadow cast by the great heights of that very same market. On the one hand, we have a technology in AI that has changed overnight the way we receive and process information—a once in a generation technology with the potential to drive growth and productivity for corporations. On the other hand, are high valuations and, in the words of Shakespeare, regular calls of bubble, bubble, toil and trouble. Investors need not pick a side.
Infinite potential futures
I just finished reading an article highlighting how today’s valuations dwarf those of 1929 and are approaching those of the Dot Com bubble. As an evidence-based investor I find historical precedent generally compelling, but these are not proof of over-valuation… just high valuation. There’s a difference. We are sitting on a new technology…AI… the impact of which is only beginning to be understood. It is possible investors are overly optimistic about AI’s potential and have pushed prices into bubble territory, but it is also possible its benefits are massively underestimated. Perhaps investors nailed the overall market value but have picked the wrong winners and losers. All of these futures are possible, as well as everything in between. Time will tell.
That’s all a bit daunting, so let’s return to where we started… euphoria. As investors we are not slaves to the unknown future. We can make intelligent decisions along the way and perhaps even capitalize on the fickle and unknowable market, bubble or not.
The do’s and don’ts
Investing success over time often comes down to a series of key moments where an investor comes up against ingrained instincts that need to be overcome. Whether it is the desire to sell out of fear of a crash or chasing irrational gains through FOMO, now could be one of those moments. Our simple advice:
- Don’t market time. We only have to go back to the beginning of 2025 for a great example. With the S&P 500 down 19% in April, fear was setting in, and nervous investors escaped to cash. But those who focused on the long-term and saw near-term weakness as an opportunity enjoyed a subsequent 40% rally! The Covid crash in 2020 and the bear market in 2022 are additional examples. Each of those moments chased some investors out of the market, but for those who held firm, from the bottom of the Covid crash to today, the S&P 500 rose over 190%. Patience beats market timing.
- Do diversify: With US Large Cap stock valuations high relative to history, the attributes of a well-diversified portfolio are as important as ever. For us, that means, a healthy allocation to International Equities, Gold, Emerging markets, and Small Cap stocks. Even within US Large Cap, investors can diversify by de-emphasizing the dominant AI mega-cap names through equal-weight funds or factors exposure.
- Do stand ready to rebalance: Better than timing the market and hoping you get it right is systematically selling high and buying low through opportunistic rebalancing. We like to let momentum run for our strategy holdings, but lock in some gains when they run too far. The same holds true if the market corrects. If AI expectations prove too ambitious, we will be ready to capitalize on cheaper valuations through rebalancing.
It’s not sexy by design. It’s science. It’s investing best practices, backed by evidence. We can’t predict the future, but we can make rational decisions based on the facts we have at every stage of this investing journey. As we look to the year ahead and beyond, I want to thank our clients, friends, and families who have asked us to be their guide and partner on this journey. We are honored to have you in our Strategic community.
About Strategic
Founded in 1979, Strategic is a leading investment and wealth management firm managing and advising on total client assets of over $2.5 billion.
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