Opinion – From Grain to Grain: Diversification has a cost; understand how much it can represent

You’ve probably heard the famous quote by economist and Nobel Prize winner, Harry Markowitz, that diversification is the only free lunch in financial markets. Investors usually confuse and relate this statement to certain gain. Undoubtedly, portfolio diversification has benefits, but this advantage is not as free as you might think.

Harry Markowitz is not Brazilian and, although he is still alive, possibly he should not have been introduced to the CDI.

In the US, it makes a lot of sense to talk about diversification, as short-term interest rates have low returns. For example, over the past 20 years, the average annual return on US government bonds with less than 3 years to maturity has been less than 2% per annum. This profitability is lower than inflation, which encourages investors to seek risk alternatives that provide higher returns.

As risk alternatives are added to the portfolio, diversification automatically becomes necessary. This need arises because, through diversification, it is possible to reduce the oscillation observed in the portfolio of risky investments.

So, realize that diversification has a risk-reducing benefit, but only for those that add risk.

Brazilian investors have an advantage over American ones. We have the CDI and the Selic. These rates of return, which are equal, have an average long-term return greater than inflation.

Surprisingly, the CDI even beat the stock market in the long run.

But that doesn’t mean you shouldn’t have a diversified portfolio. But yes, diversification is necessary when adding any risky asset. Such a portfolio may bring higher returns, but they will charge a cost.

For example, consider the following risk assets. This table contains eight assets. Four are fixed income indexes and four are variable income indicators.

Fixed income assets can also contain risk. See in the graph that the average of titles referenced to the IPCA and prefixed fluctuate and even present negative returns.

An asset is considered fixed income when its rate of return to maturity is established in a contract. As for a variable income asset, its return, for any term, is not determined in the contract.

In the table above, the MSCI ACWI asset represents the weighted return of 23 developed and 24 emerging market equities. This profitability in the table contains the exchange rate effect in dollars and could represent the result of international investment.

Assuming each asset with the same weight in the portfolio of a moderate investor, all would have an individual weight of 12.5% ​​in the portfolio.

The table below shows the return on this diversified portfolio over the last ten years ending in 2022. The accumulated return reached 168%, which is equivalent to 128.2% of the CDI.

Despite having beaten the CDI in the accumulated period, in half of the years the return was below the CDI. In 2022, the return was only 31.4% of the CDI.

Thus, if you want to beat the CDI, you will need to take some risk. However, if you have any risk, even diversifying, you will lose the CDI in some period.

Losing the CDI in some period is a cost for those who diversify, as they chose to have some level of risk.

Having only assets referenced to the CDI reduces your risk of oscillation and provides a good return. However, it does not guarantee that you will always beat inflation.

Therefore, even for conservative investors with a long-term horizon, the ideal is to have a balance between CDI-linked and IPCA-linked securities with maturities of less than five years.

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

Talk directly to me on Whatsapp.

Follow and like De Grão em Grão on social networks. Follow the investment lessons in Instagram.

If you have any questions or suggestions for themes, please feel free to send by email.