Arthur G. Swalley, CIMA® – Director of Investments
Why Does Diversification Work?
The past two years in the capital markets are a textbook example of how diversification works. Being thoughtfully distributed among multiple asset classes has brought strong returns, without suffering the extreme volatility of each of those independently fluctuating asset classes. More importantly, why does it work? In our view here at Arlington, 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 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 introduces far too many variables for our brains, or even computer modeling, to accurately and consistently predict future returns. But we are hard-wired to keep trying! Our attempts continually produce short term volatility and reversals, which produce regret and avoidance behavior – also psychologically hard-wired. Proper diversification smooths out these ever-present anomalies and gives us 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. We want to 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 of assets – trimming back what is currently up in value and buying more of what is down – we are better able to effectively participate in the long term growth of the overall market. 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. 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 will continue our discipline of diversification and rebalancing. We wish you a happy, healthy, and successful 2022!