Q1’s Biggest Lesson for Investors: Diversification Works

For all the turmoil in the news lately, investors who stuck with the tried-and-true strategy of holding diversified portfolios have come out of the first quarter of 2025 with barely a scratch.

There’s no question that the quarter did not turn out the way most pundits thought it would. US President Donald Trump’s trade wars and significant breaks with the longstanding geopolitical order turned recent stock and bond market trends upside-down. US stocks went from record highs to suffering the losses of a 10% “correction” in less than a month. A previously solid outlook for the US economy has been hit by a high degree of uncertainty, thanks to swings in trade policy and federal government layoffs.

Against this backdrop, high-flying technology stocks that had been big winners for nearly two years collapsed by double digits. The Morningstar US Technology Index fell 12.06%, its worst quarter since the second quarter of 2022 (when it lost 22.33%).

However, while the parts of the stock market that got bloodied are interesting and important, a focus on them misses the full picture. Under the hood, there was widespread evidence of an investor rotation out of the more expensive, riskier parts of the market to names that previously lagged and were trading at lower valuations. At the same time, many key non-US stock markets rallied, and bonds held steady, offering ballast.

“Diversified, balanced portfolios have worked as intended in the first quarter of 2025 amidst heightened market volatility,” says Dominic Pappalardo, chief multi-asset strategist at Morningstar Investment Management.

Q1’s Wide Value vs. Growth Split

While the overall US stock market finished the first quarter in the red, with a 4.6% drop in the Morningstar US Market Index, that decline masked a wide dispersion of performance.

There are times when there are no safe havens in the equities market. The 2020 covid-driven plunge is one example. But that wasn’t the case this time around.

This can be seen with the broadest brush: value vs. growth. Going into 2025, growth stocks were on a tear, led mainly by big technology names. The Morningstar US Growth Index surged 23.42% in 2024, leaving the Morningstar US Value Index in the dust with a 13.77% return. During the first quarter, however, growth stocks fell 9.24%, while value stocks rose 4.44%. That’s a nearly 14-percentage-point difference.

There was a similar disparity between large growth stocks, which fell 7.53%, and large value stocks, which gained 5.95%.

“US large cap growth stocks, which had been buoyed by the stellar performance of the ‘Mag 7′ [Nvidia NVDA, Meta Platforms META, Apple AAPL, Amazon AMZN, Microsoft MSFT, Alphabet GOOGL/GOOG, and Tesla TSLA] over the previous two years, sold off strongly in the first quarter,” Pappalardo says. “This is another example that demonstrates valuations matter most amid uncertainty. There is no doubt the ‘Mag 7′ companies are among the strongest in world, and they displayed incredible growth in both revenue and earnings recently. But their stock prices were just simply too high.”

Tech Stocks Down, Defensive Sectors Up

Looking at the sector level, the mixed performance within the stock market becomes even clearer.

Consumer cyclical stocks (which are dominated by heavy weightings in Amazon and Tesla) was the worst-performing sector during the first quarter, with a 12.83% decline. Technology stocks lost more than 12%.

Despite that bloodletting, seven out of the 11 sectors posted gains in the quarter. That ranges from a 2.35% return on basic materials stocks to a 9.03% return on energy stocks. Second-best for the quarter was healthcare, with a 5.45% return.

Notably, basic materials, healthcare, and energy were the three worst-performing sectors in 2024.

“Technology and communication services led the way down, losing double-digit percentages after leading the rally in 2023 and 2024,” says Pappalardo. “Conversely, sectors like utilities, consumer staples, and healthcare all had positive performance and outperformed the broad market meaningfully after lagging for the previous couple of years. This is a great example where investors that were disciplined and continually rebalanced their portfolios to match their risk targets avoided undue concentration in those previous standout sectors and maintained prudent diversification.”

Non-US Stocks Gained in Q1, While the US Market Sagged

Pulling the lens back out, diversification across global markets also paid off during the first quarter. To some degree, idiosyncratic trends were at work. For example, China saw stocks rally on expectations that stepped-up stimulus efforts would bolster its economy. Even after a late-quarter pullback amid tariff concerns, the Morningstar China Index finished the quarter up more than 14%.

In Europe, President Trump’s pivot away from supporting various defense needs led to a massive rally in European defense stocks. The biggest shift came in Germany, as the government cast side decades of fiscal limits on defense spending. The Morningstar Germany Index jumped 15.63% in the first quarter. Stocks in the United Kingdom, Spain, Norway, Italy, and Ireland also posted strong gains.

“This is a strong reminder that global diversification can serve investors quite well, because trends reverse, typically no single country or region can lead performance indefinitely, and it’s impossible to predict what the impetus for those reversals will be,” Pappalardo says. “The US was trading at a much richer valuation compared with these European countries coming into 2024 by any measure.”

Bonds Back to Being Ballast

One of the most important success stories for diversification in the first quarter came in the bond market. The 2022 bear market in stocks hit many investors harder than usual because it was accompanied by the biggest government bond market selloff in modern history. For investors counting on bonds to help smooth out the stock market’s inevitable ups and downs, the year was a disappointment. That led to questions about the wisdom of so-called 60/40 portfolios (which hold a traditional asset mix of 60% stocks and 40% bonds).

But during the first quarter, bonds were able to withstand headwinds from stubbornly high inflation and the Federal Reserve putting interest rate cuts on hold as Trump’s tariffs clouded the outlook. Instead, investors focused on evidence of a slowing economy, which is a positive for bond prices.

The result was a 2.78% return on the Morningstar US Core Bond Index, a 2.93% gain on the US Treasury Bond Index, and a 4.25% return on Treasury inflation-protected securities.

“The traditional relationship between stocks and bonds resurfaced in the first quarter,” Pappalardo says. “Historically, these asset classes move in opposite directions, especially in times of volatility or equity market drawdowns. Given that interest rates were much higher entering 2024 than they were entering 2022, bonds held up quite well and offset some of the losses from equity allocations. In other words, bonds served the purpose they are intended to from a portfolio diversification and risk perspective.”

The benefits of a stock and bond mix can be seen in the Morningstar US Moderate Target Allocation Index, which tracks a global mix of 60% stocks and 40% bonds. During the first quarter, the index lost 0.8%. That’s still a negative, but considering the drop in the overall stock market and the double-digit declines in the equities that had been the bull market’s big winners, the benefits of diversification came through.