By Fernando Donnay, partner and member of G5 Partners’ management team.
Diversification is an advice given to every investor: “Don’t put all your eggs in one basket”. More than just a popular saying, this is a strategy that has been proven to minimize losses when unexpected events occur. The Nobel-winning economist Harry Markowitz, creator of the Modern Portfolio Theory, described diversification as “the only free lunch” for investors. In essence, his theory demonstrates that a strategic allocation based on the calculation of risk and correlation between assets allows investors to build portfolios that optimize returns within an acceptable risk level.
What does history teach us?
A recent study from Morningstar[i], which analyzed nearly half a century of data in the United States, confirms the importance of diversification when it comes to reducing risk. However, it has been discovered that a simple portfolio breakdown consisting of 60% equities and 40% fixed income assets often outperforms more sophisticated portfolios in terms of risk and return. What is also interesting is that Markowitz himself used a simplified approach for his personal finances, allocating 50% of his assets in equities and 50% in bonds. This reinforces the idea that well-executed basic principles can often be the most effective response to market uncertainties.
The paradox of the Brazilian investor
In Brazil[ii], savings accounts are still among the leading investment preferences, corresponding to 25%, reflecting a conservative profile in search of security, particularly during times of economic instability and high inflation. However, there is an intriguing paradox: despite the risk aversion towards traditional investments, Brazil has one of the largest online betting markets, with investors choosing cryptocurrencies over public Treasury bonds (4% versus 2%). It’s like saying “I don’t want to take chances” while, at the same time, making high-risk gambles. This duality shows that Brazilians are seeking quick gains, even those who declare themselves as having a more cautious investment profile.
Time: our greatest ally for diversification
Time is one of the strongest pillars for successful diversification. While many Brazilians seek immediate returns – such as online bets – focusing on a long-term horizon allows diversification to reveal its full potential, softening asset volatility and balancing economic cycles. For example, despite having faced decades of negative performance, the S&P 500 has demonstrated solid long-term returns. Other alternative illiquid investment options, such as private equity and venture capital, require patience but offer potentially higher returns for those who endure lower liquidity. At the end of the day, aiming for quick market gains is like gambling at the casino: a recipe prone to frustration in the long-term.
If diversification is so good, why don’t people do it?
Daniel Kahneman, an economics Nobel prize winner, explored how behavioral and cognitive biases influence investment decisions, often in a suboptimal way. Even Markowitz, known as the master of diversification, adopted simple approaches that sometimes contradicted his own theory. A notable example is the Magellan Fund, managed by Peter Lynch, which had annual average returns of 29.2% for 13 years. However, many shareholders lost money by investing at the wrong time, purchasing shares at higher prices and selling when prices dropped. These emotional biases cause many investors to ignore the importance of diversification, making them wrongfully believe in the ability to “hit the jackpot” by purchasing specific shares or taking on risky bets.
Conclusion: diversification, patience and having a long-term perspective
Diversification remains an essential strategy for those seeking security and the sustainable growth of their investments, including in Brazil. Even when faced with changes in asset correlation and a challenging economic scenario, diversification is still proven to be the most effective approach for portfolio protection during market uncertainties. Markowitz’s saying that diversification is “the only free lunch” still resonates and, although portfolio performance is not guaranteed, it allows a healthy balance between risks and returns.
Within the Brazilian context, in which conservative profiles contrast with the willingness to take on risks in crypto assets and sporting bets, it is essential to understand and mitigate personal behavioral biases. The conscious use of diversification and long-term perspective are key elements that can be used to your advantage when facing turbulence and seizing opportunities. However, during short-term horizons, it is important to resist the temptation for quick gains. It may be wiser to choose safer investment options, such as floating and inflation-linked Treasury bonds.
Diversification: the only “free lunch” for investors?
In Brazil, there is an evident paradox: while savings accounts are the leading conservative investment option, cryptocurrencies and online betting are increasingly gaining more space.
Our first G5 Insights discusses diversification and long-term perspectives for investments. Our partner and member of the Management team, @Fernando Donnay, wrote an excellent review on this topic.
The secret to navigating between security and sustainable growth? Diversification, patience and having a long-term perspective.
[i] Diversification Landscape_2024 – Morningstar
[ii] 7th edition of the Raio X Brasileiro report – Anbima.