Opinion – Grain in Grain: Find out how much a diversified portfolio has yielded in the last decade

The concept and effects of diversification are still poorly understood by most investors. Many believe that with diversification you are able to produce a portfolio that would never lose the CDI. Others attribute to diversification the power to always produce more returns. Below I discuss these concepts and how much a diversified portfolio with a moderate profile has yielded in the last ten years and in 2022.

Let’s start with the concept of diversification and what a moderate profile portfolio represents.

There is no fixed distribution for a portfolio to be defined with a moderate profile.

The profile depends a lot on the type of product. For example, a portfolio could be formed 100% by a very low risk hedge fund and still be considered conservative.

The profile is also linked to the investment horizon. For example, an investor, who intends to invest for a period of one year, would be being aggressive if he invested entirely in fixed income referenced to the IPCA or fixed-rate with a maturity of more than 10 years.

Therefore, the profile of the portfolio does not only depend on the distribution of asset classes, but also on the type of product and the investment term.

In general, investment portfolios with a distribution of 40% to 80% in fixed income can be considered as moderate. In our example, we will consider a portfolio made up of 60% in fixed income.

Diversification is not just about splitting into multiple assets. In order to have adequate diversification, it is important to distribute among asset classes that have less correlation.

Correlation is a statistical concept that measures the joint movement relationship between asset returns. Two assets would be perfectly correlated if they always move in the same direction, that is, whenever one has a positive return, the other also goes up. The less they vary in the same direction together, the less their correlation.

Note that what counts to measure the correlation is the direction and not the intensity of the joint movement between the assets.

The table above presents the annual returns of eight asset classes that investors tend to distribute their portfolios.

Assume that an investor builds a diversified portfolio, distributing his portfolio 60% evenly among the four fixed income assets and 40%, also equally, among the four risk assets.

The table below presents the annual return of this diversified portfolio.

From 2012 to the end of July, this portfolio would have lost the CDI in five of the eleven years.

This year, the portfolio would be presenting the second worst year of the last decade. The return of only 12% of the CDI is a disappointing result for those who decide to take a risk.

Looking at the year 2022 in isolation, an investor could argue that diversification would not pay off.

Perhaps an investor would imagine that he would have performed better if he had spread 100% over just the four fixed income investments over the past eleven years.

The graph above shows the evolution of an investment of R$ 100 in the fixed income portfolio and in the diversified portfolio.

It is possible to see from the graph that the diversified portfolio had a higher return, but the benefit was not just that.

We can measure risk by volatility, that is, by the dispersion of returns.

If we calculate the ratio between return and risk, we have a known Sharpe ratio that measures the return per unit of risk.

Sharpe in the diversified portfolio was 1.48, against 1.42 in the fixed income portfolio.

Although in the short term they may present less favorable returns, for the long term, diversified portfolios should still result in a better balance of return per unit of risk.

Michael Viriato is an investment advisor and founding partner of Investor’s House

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