The Best Investment Writing Volume 3: Mike Philbrick – Diversification: What Most Novice Investors Miss About Trend Following

Episode Summary

Executive Summary: This episode argues that novice investors misunderstand trend following by focusing on single equity indices, when the real advantage comes from diversification across many markets and asset classes. Using examples from moving-average trend rules and capital market theory, the speaker shows that broad, multi-asset trend portfolios can deliver higher risk-adjusted returns, and often higher absolute returns when prudently leveraged.

Main Topics: Trend following is not just equity market timing (Priority: 5/5): The transcript contrasts novice use of simple moving-average rules on stock indices with professional trend following across dozens of futures markets spanning equities, bonds, currencies, commodities, and even niche markets. Diversification as the core source of trend-following success (Priority: 5/5): The central thesis is that the main edge in trend following comes from trading many markets together, where uncorrelated returns smooth volatility and improve consistency. Capital market line and leverage (Priority: 4/5): The speaker uses modern portfolio theory to argue that investors can pursue higher returns by holding diversified efficient portfolios and using leverage, rather than concentrating in equities. Single-market versus diversified equity trend strategies (Priority: 5/5): A comparison of individual equity index trend strategies versus a diversified basket shows large dispersion across countries and a meaningful diversification bonus for trading all equity indices together. Diversification beyond equities (Priority: 4/5): The argument is expanded to bonds, currencies, and commodities, showing that diversification benefits persist and are often even larger outside equity markets. Access and implementation through liquid alternatives (Priority: 3/5): The transcript closes by noting that diversified futures strategies are increasingly accessible through mutual funds and liquid alternatives, with additional benefits such as tax treatment and capital efficiency.

Key Arguments: Trend following on one stock index is a narrow, novice application that ignores the primary source of performance: diversification across many uncorrelated markets. Professional trend followers trade across asset classes because individual market outcomes are highly variable, but portfolios of markets produce more stable returns. The capital market line implies investors can earn more return per unit of risk with a diversified portfolio than by concentrating in equities. If an investor wants higher expected returns, it is often better to leverage a diversified portfolio than to move farther out on the equity-heavy efficient frontier. The distribution of returns across individual equity index trend strategies is wide, so choosing one market at random is a poor way to implement trend following. Trading all equity indices together materially improves risk-adjusted returns versus a median single-market strategy because market signals are not perfectly correlated. The same diversification bonus appears in bonds, currencies, and commodities, where individual markets may be weak but the portfolio effect is strong. A truly diversified multi-asset trend strategy can outperform most individual strategies and rivals some of the best-known hedge fund approaches. Liquid alternatives have made diversified futures strategies more accessible to non-qualifying investors. Futures-based strategies can also be attractive because of favorable tax treatment and capital efficiency.

Data Points: 200-day moving average / 10-month lookback: Used as the trend-following rule - The strategy buys when price is above the moving average and exits when below Historical equity trend strategy performance: Similar returns to buy-and-hold over the very long run, with lower volatility and smaller maximum drawdowns - Referenced from Jeremy Siegel's discussion of trend rules Capital market line example volatility target: 15% annual volatility - Used to compare concentrated equity portfolios versus leveraged diversified portfolios Concentrated portfolio composition: 29.4% long treasuries, 18% Asian stocks, 52.6% emerging stocks - Highest-return portfolio at 15% volatility under the assumptions given Excess return for concentrated portfolio: 4.8% annual excess return - Expected return for the 15% volatility concentrated portfolio Excess return for leveraged diversified max-Sharpe portfolio: 6.45% annual excess return - Higher-return outcome when leveraging the diversified portfolio Return advantage of leveraged diversified portfolio: 1.65 percentage points per year - Compared with moving out the efficient frontier into concentrated equities Worst single equity index trend result: Just over $2 from $1 - Over 35 years in the least favorable market example Best single equity index trend result: Over $16 from $1 - Over 35 years in the most favorable market example Equity index trend Sharpe ratio - random single market: About 0.45 - Expected outcome if choosing one equity market at random Equity index trend Sharpe ratio - diversified strategy: 0.76 - Trading all 15 equity index futures as a diversified system Return-per-risk improvement: 1.69x - Diversified equity trend strategy versus a random single equity market Sharpe ratio of S&P 500 trend strategy: 0.51 - Compared against the diversified global equity trend strategy Commodity median Sharpe ratio: 0.5 - Median among 20 commodity market trend strategies Commodity diversification bonus: 2.29x - Return per unit of risk versus trading one random commodity market Diversified strategy performance threshold: Better than 93% of individual strategies - To beat the diversified strategy, an investor would need to choose a market ahead of time with very high accuracy Asset counts analyzed: 15 global stock index futures, 6 bond futures, 7 currency futures, 20 commodity futures - Scope of the diversification analysis across markets

Pivotal Quotes: "Diversification is key. The more diversification, the bigger the impact." — Mike Philbert: Core thesis repeated throughout the episode to emphasize why broad market exposure matters "If you trade just one market, you never really know how you're going to do. But if you're trading markets across the board, you have a good chance of earning a nice return with less volatility." — Larry Heid: A cited anecdote illustrating the benefit of trading many markets rather than concentrating "The true benefit of trend following is only realized when investors take advantage of the extreme liquidity and diversity of global futures markets to trade a wide range of markets across all major asset categories." — Mike Philbert: The concluding argument summarizing the episode's central message

Implications: For investors, the message is to stop treating trend following as stock timing and instead use broad, multi-asset diversification. For the industry, it supports liquid alternative products that package diversified futures strategies for a wider audience.