The Strange Paradox of Diversification

Sitting through the most tedious Super Bowl in recent memory did at least give me the opportunity to connect it with my theme for this quarter’s letter, the strange paradox of diversification in good times. It’s been tempting to see the success of the New England Patriots as down almost entirely to their legendary quarterback, Tom Brady (and maybe a little bit to Gronk...). This year, when Brady’s prowess was seemingly blunted (and Gronk barely figured), they still emerged victorious, due to an outstanding defensive performance that no one expected, coupled with a game winning receiving performance from a historically underappreciated Julian Edelman.

The paradox arises because for many years, money spent on the defense (and perhaps even Edelman) would have been viewed as a complete waste (along the lines of “why do we need (defense) when we have Brady...”). Then finally in a match where offensive points were hard to come by, the value of the defense came to the fore. (Although space limits my ability to fully develop the analogy, just in case anyone thinks I have gone totally native, you can make the same observation around the strategy and team development within “true football” i.e. soccer, for example, with Lionel Messi at Barcelona.)

There’s a strong parallel with diversification in investments. In some market conditions, it can go completely unrewarded. Indeed, in the short term, making the right choice – building a robust total portfolio – can often actually seem to cost both returns and money. If the obvious single asset performs the best, then in pure results terms, diversifying from that asset leaves us worse off in the short term, even if the actual portfolio chosen a priori had been a much more robust design.

I am prompted in these thoughts because, while 2018 was a relatively traumatic year for both equities and bonds, it came after one of the most benign periods for these assets that we have ever seen. In the case of equities, commentators mark the start of the latest bull market from the troughs around the end of Q1 2009, and indeed the returns have been stellar. Of course, what is rarely mentioned is that, at the time, it felt like there was a 50% probability of the end of capitalism, and prices reflected that (or the attendant fear if you prefer). Unsurprisingly, once you take that risk off the table, equity prices were rebased in a major way. In the case of bonds, the environment has been even more favorable if that were possible: a 30-year bull market initially triggered by a long cycle of disinflation in part driven by a one-time globalization of the world economy, then followed over the last decade by a hunt for yield that has spread right across the capital spectrum and seen more than $2 trillion deployed into the asset class.

On top of those benign fundamentals, the party was for many years further invigorated by a global wave of quantitative easing (QE) that’s now coming to an end (and already has here in the US). We probably still need more distance from QE to diagnose its effects fully, but a reasonably well held view (that I share) is that it helped perpetuate both equity and bond bull markets – probably not a surprise when central banks are pumping money into the capital markets on top of normal demand! What we don’t know is what happens as they withdraw that same money – but it’s hardly unreasonable to imagine some opposite effects.

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