May 27, 2022
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Opinion: Diversification works; here’s why

IN THIS ARTICLE

By Arthur Swalley

The past two years in the capital markets are a textbook example of how diversification works.

After the pandemic crash in February and March 2020, market returns were led by “pandemic” stocks like Zoom and Amazon. As interest rates remained low, resulting in higher multiples being placed on growing cash flows, large technology companies like Alphabet and Microsoft took over leadership, accompanied by a speculative surge in smaller rapidly growing companies.

Arthur Swalley

Real estate, driven by strong demand thanks to low interest rates, and limited supply as housing construction waned after the 2008 real estate crisis, enjoyed double digit returns.

Then, as anti-COVID vaccines helped the economy move towards reopening and oil prices rebounded in 2021, investment capital redirected out of the high-flying growth stocks and into traditional industrial “value” companies.

Being thoughtfully diversified among these multiple asset classes has brought strong returns, without suffering the volatility of each of these independently fluctuating asset classes.

More importantly than how it works, why does diversification work? In our view at Arlington Financial Advisors, diversification works because of the behavior, and misbehavior, of investors.

The core of this concept is the proven risk and difficulty of predicting what will happen next in financial markets based on pattern recognition. Prior to the Industrial Revolution, humans were generally rewarded for recognizing patterns and taking advantage of them for survival. Simple examples include following animals’ predictable migratory patterns for effective hunting, tracking repeating weather patterns for timely crop planting, and observing the hunting patterns of potential predators. Pattern recognition is wound deeply into our psyches because of its importance to human survival.

As economies developed from trade and barter systems to complex market-based monetary systems, humans have naturally continued to apply pattern recognition to markets, because we perceive them as being a key to survival. However, the volume and complexity of data inputs into modern markets introduce far too many variables for our brains, or even computer modeling, to predict future returns accurately and consistently.

But we are hard-wired to keep trying! Our attempts continually produce short term volatility, manias like “meme” stocks and cryptocurrencies, and periodic market upheavals, which produce regret and avoidance behavior — also psychologically hard-wired.

Proper diversification smooths out these ever-present anomalies and gives investors more consistent returns with less risk. The goal becomes owning more of the good quality assets others are avoiding, rather than buying up “hot” assets at high prices.

Diversification helps take advantage of hard-wired pattern recognition and the resulting misbehavior of investors who project past returns into the future. When combined with consistent rebalancing — trimming back assets currently up in value and buying more good quality assets that are temporarily down — investors are better equipped to effectively participate in the long-term growth of the overall market economy.

In the spirit of this column, we will avoid predicting what will happen to markets in 2022. What we can say is that the Federal Reserve is on the record for hiking interest rates this year. Market reaction has been swift: Through Feb. 4, intermediate term investment grade bonds are down nearly 3%.

We know that historically, the beginning of interest rate rising cycles has never signaled the beginning of recessions. We also know that there are exceptions to every rule, so we continue advising disciplined diversification and rebalancing.

• Arthur G. Swalley is a partner and director of investments at Arlington Financial Advisors in Santa Barbara.