Diversification Not an Accident

William Bernstein wrote “the only black swans are the history that investors have not read.”

Black swans are a metaphor for rare events, ones that come as a surprise.

Silicon Valley Bank (SVB) is the most recent example. It’s rare for a bank to fail and certainly came as a surprise. But the rare and unexpected occur more often than we think.

This is a feature of markets and investing, not a bug. Problems from time to time should be expected – an inescapable part of life.

Recently, there’s been no shortage of them. Inflation, interest rates, and recession-mongering captured most of last year and followed us into this year.

Now add a banking crisis to the mix.

Buffett has the old saying, “there’s never just one cockroach in the kitchen.” The banking issues have many people asking, “what’s the next domino to fall?”

Rumors say commercial real estate could be in trouble. The banking industry and commercial real estate are closely connected. The logic goes:

• Banks increased their exposure to commercial real estate heading into the pandemic, particularly in metro areas in sectors like office and retail.

• Now a record number of commercial mortgages are expiring this year, roughly $270 billion worth per Trepp.

• Most of these loans are held by small banks (those with less than $250 billion in assets), according to the Wall Street Journal.

• SVB’s collapse was triggered by unrealized losses from its bond portfolio. Potential losses from commercial real estate loans – in the event of defaults – could be much higher.

• Borrowers ability to make good on those loans is a worry. Rising interest rates plus falling demand for commercial real estate could create price declines.

• The twin worries for banks = defaults rising & real estate prices falling.

• In both scenarios, banks commercial debt portfolios would fall in value. And both of those may feed off each other. Lower prices create more defaults as more borrowers go underwater.

In summary, fear is palpable. Consumer sentiment reflects this, hovering near all-time lows.

Investor sentiment data shows the same result. AAII data of investors that are “bullish” also hovering near multi-decade lows.

So, where do we go from here?

The easiest thing that can be said is handicapping the outcome is no easier than picking winners in March Madness. ESPN reported 20 million brackets were filled out on their website for the event, yet only 37 picked the Final Four correctly. Sometimes the consensus choices aren’t necessarily the correct ones.

There are a couple easy things to remember in times like these:

1) The best investment opportunities mostly arise from fear and pessimism.
2) Diversification is not an accident; it prevents you from being over-exposed to any single outcome.

Diversified portfolios – like airplanes – are built to withstand turbulence, allowing investors to avoid any single point of failure.

Diversification is often talked about at 20,000 feet; owning a collection of stocks, bonds, and maybe even alternatives.

But diversification should also be done within each of those asset classes. Using stocks as an example; ideally you should be diversified across regions, countries, and sectors.

The US only makes up 60% of the globe’s total equity market. There’s ample opportunity to invest outside the US — and benefits for doing so — as international and emerging markets will outperform US stocks again at some point. (Yes, the last decade proved otherwise but it won’t hold true forever.)

At the sector level, most investors own banks (which is not fun right now) but if you own a collection of other US industries your portfolio is likely positive since the banking crisis began, as those areas of the market have performed better.

In short, diversification – done well – has many layers that compound on one another to create a resilient foundation, capable of handling any market environment.

In any given year, when the annual returns of the year’s biggest winners are published, practitioners of diversification are not on that list.  

Howard Marks talked about this reality in 2017 on the podcast Masters in Business stating:

“Early in my career, I went to the Midwest and met with the head of the pension fund for General Mills. He explained to me over the 14 years he had run the fund his performance was never above the 27^th percentile and never below the 47^th percentile in any year. As a result, he idled near the middle in terms of performance versus peers over those 14 years. The funny math about our business is he ended up in the 4^th percentile for the entire 14-year period.”

Lesson #1: investment performance in the 50^th percentile every year will likely end up in the top 5-10% over long periods.

Marks went on to add:

“I met with another manager later on who told me if you want to be in the top 5% of money managers you have to be willing to be in the bottom 5% from time to time. To which I thought, how wrong can you be? My clients don’t care if I’m in the top 5% and they’re absolutely unwilling to be in the bottom 5%. I like the other approach where you’re steadily above the middle and that pushes you towards the top over the long run.”

Lesson #2: Most people who do really well for a while eventually shoot themselves in the foot and the effects on long-term performance are enormous.

In that sense, diversification can be viewed as a form of delayed gratification. The benefits may not be easily identified in any single year, but the long-term benefits are enormous.

Given what’s transpired, the future is incredibly murky, or so it’s been said, but this is not abnormal. The future is always highly uncertain.

Zooming out from present, and thinking about the future, the below chart is one of best illustrations of the power of long-term thinking.

On any single day, it’s basically a coin flip whether the market will be up or down. But the further you extend the time horizon the better your chances become.

Now parallel the above with what’s happened in recent weeks. Certain parts of the market have exhibited casino-like characteristics. It’s been normal to see +/- 20% stock price moves for banks in the line of fire from the SVB fallout.

It’s important for investors to know they don’t have to play that game. The stock market is only a casino if you allow it to be.

There’s a much simpler game to be played, which boils down to timeless investing principles of ignoring short-term noise and focusing on the long-term probabilities of success.

Admittedly, this is easier said than done.

But diversification is likely the greatest tool for enabling long-term success, helping investors withstand the black swans that happen from time to time, keeping you invested through them, and ultimately tipping the odds in your favor.

Nobody can predict the future, but panic is not an investment strategy; neither is “get me in” nor “get me out.”

Luckily, if you’re diversified, you don’t need to predict the future. Diversification is not an accident.