Diversification Fundamentals: Key Concepts

Concept 1: Returns Are Not the Most Important Thing

• Do not look only at returns or ignore risk. You can see returns. Risk is what you cannot see.

Concept 2: The Long Term

• Keep your investments for the long term. You need to survive the market, and the long term is usually associated with compound interest. Looking at the short term gives you a false view of the broader picture. So ALWAYS diversify for the long term.
• The long term is the shortest path to wealth.

Concept 3: Capital Preservation

• The more you lose, the harder it is to recover your capital. If you have 100 reais and lose 75, you have 25 left. You then need a 300% return (4x) to get back to where you started.
• Diversification is not a shield. It is a sword!

The Three Layers of Risk

1. Within an Asset Class

• Owning only one stock is not enough. A diversified portfolio gives you more protection because you spread your risk across more holdings. Be careful, though. Too much diversification may not make a real difference and can fragment your investments.

Unsystematic and Systematic Risk

• Unsystematic: This risk is tied to a specific asset and includes risks inherent to a sector. Owning several stocks in the same sector is not enough. In the first layer of diversification, I should own stocks in different sectors. The idea is to find the best company in each sector. The more sectors I own, the more I reduce my risk. More stocks = more security.
• Systematic: Risk that cannot be diversified away. It does not depend on a specific sector, but on broader issues.

2. Asset Classes

• You do not need to choose only the best work of art. You might instead hold a diversified collection. The few works that grow above average can justify the others and make a real difference. Entrepreneurship works the same way: you need one big success to become wealthy.
• I also need to diversify my wealth across asset classes. Choose different assets within each class.

3. Across Countries

• Diversification brings security and optionality. It is also about multiplying opportunities and getting exposure to small spikes.
• We have a crisis about every five years. How can we diversify systematic risk? Prepare before it happens through diversification and rebalancing. We can reduce the effect of systematic risk because it usually takes the form of a sharp drop followed by a quick recovery. During the pandemic, for example, while stocks fell here, people with part of their wealth diversified and invested in dollars felt the drop less.

Correlation

Correlation is a statistical measure of how two assets move in relation to each other.

• It measures how one asset fluctuates relative to another. For example, if one asset falls 1% and the other rises 1%, they have perfect correlation.
• A correlation above 0.5 is a strong positive correlation and usually means very similar movements. A correlation below -0.5 is a weak negative correlation.
• We need several assets that are uncorrelated or negatively correlated. If they are all positively correlated, they may all fall together at some point.
• When the stock market rises, the dollar often falls because investors buy reais, which makes the real appreciate. When the market falls, the dollar often rises because investors sell reais and buy more dollars.
• In short, with strong positive correlation, I am not diversifying my wealth. I need negative or low correlation.

Convexity: You Can Gain Much More Than You Can Lose

• Stocks are convex: the maximum risk is losing 100%, but the upside is almost unlimited.

How do you calculate correlation in Excel?

Let’s calculate the correlation between the U.S. dollar/real exchange rate and the stock market (IBOVESPA). We want to know the correlation between one asset and the other.

• Correlation between the two assets.

  Correlation Level	Meaning	Interpretation
  +0.5 to +1.0	Strong positive correlation	Movements are very similar most of the time
  +0.2 to +0.5	Weak positive correlation	Movements are similar much of the time
  -0.2 to +0.2	No correlation	Movements are unrelated
  -0.2 to -0.5	Weak negative correlation	Movements are opposite much of the time
  -0.5 to -1.0	Strong negative correlation	Movements are opposite almost all the time

A strong negative correlation indicates an inversely proportional movement.

Comparing Risk and Return

• Do not look only at returns. You must analyze risk and look for assets with the best risk-return ratio. Always consider risk to reduce negative surprises during your investment journey.

ÍNDICE DE SHARP:

30% (Retorno) - 4% (Taxa Livre de Risco)
------------------------------------------ = 2,6%
10% (Volatilidade)

vs

20% (Retorno) - 4% (Taxa Livre de Risco)
------------------------------------------ = 5,33% (Retorno/Unidade de Risco)
3% (Volatilidade)

• We can conclude that option 2 is better here. It offers a higher return for each unit of risk, even with lower volatility.
• One piece of advice: you can gain a lot, but you can also lose everything. Never look at returns in isolation.

Diversification During Crises

Crises can create major opportunities in financial markets. They are severe because they are unexpected. Crises will always happen, and preparation does not help if you are caught off guard. A diversified portfolio can reduce losses during a crisis. Turn crises into opportunities through a methodical approach to diversification. Choose good assets.

The A.R.K. Method

The goal is to prepare for a great flood by building an ARK.

• A - Stocks / Assets
  • We often start by selling our time, but this does not scale much. Starting a business is the next step because we create value for the market. By buying stocks, we can share in the growth and profits of other companies and become partners in businesses led by entrepreneurs we believe in. But stocks alone do not make much sense because we are exposed to a single source of volatility.
• R - Real Estate
  • Businesses usually have a physical location. They can own or rent it. If people pay rent, someone receives it. Real estate funds are one way to participate in the business as a rent recipient.
• K - Cash
  • Cash helps us take advantage of and survive crises. Cash refers to the portion of wealth allocated to fixed income for long-, medium-, and short-term goals, including an emergency fund. It is more conservative than the other options.
• A - International Assets
  • Keep part of your portfolio outside your country to diversify and gain exposure to negative correlations.

The Lindy Effect

The longer something has existed, the longer it is likely to continue existing.

Rebalancing

Diversification and rebalancing work well together. The idea is to rebalance when one of the four areas falls during a crisis. Move resources from the area that gained the most to the one that fell, so the four ARK areas stay balanced.

• Cash can help you buy assets at lower prices.
• Real estate can generate monthly income to reallocate.
• International assets can protect against the dollar and currency fluctuations.

Ways to Rebalance

1. Rebalance with your salary by reinvesting money in the asset class you hold the least.
2. Rebalance with dividends by buying more of the asset class you hold the least.

How Can You Improve Rebalancing?

Mandatory rebalancing starts when one asset is more than 40% of your portfolio. It is important to set a dollar value and a floor. The idea is to lose little.

Indexes matter because they give us a benchmark. IBOVESPA represents the most liquid stocks on the Brazilian exchange; IFIX represents real estate funds; the S&P 500 represents the 500 most liquid U.S. companies; and Tesouro Selic represents fixed income.

• You can easily build an ARK with four assets, or four ETFs, one for each area.

How to Balance Your Investment Portfolio

💡 Carteira Holder - Website

Convexity

Always keep part of your ARK for some convexity, meaning exposure to options and changes in the economy that we cannot predict, as happened with Bitcoin. Never build a concave investment portfolio. Build a convex one!

How to build your ARK with ETFs in practice

You can build a simple portfolio with ETFs in three ways.

OPTION A: SAFE

OPTION B: MODERATE

OPTION C: AGGRESSIVE

Analyzing ETFs

• BOVA11: Managed by BlackRock.
  • It has 91 different assets, is fully ESG, and has an annual management fee of 0.1%.
    • VALE3, ITUB4, PETR4, ITSA4, and others.
• IVVB11: A Brazilian ETF that invests in a U.S. ETF.
  • It has a 0.23% annual management fee and invests in the S&P 500, the dollar, and cash in reais.
• XFIX11 and SMALL11:
  • XFIX is managed by XP Inc.
  • SMALL11 is managed by BlackRock.
    • Azul4, LWSA3, LCAM3, GOAU3, TAEE11, and others.
• HASH11: A crypto ETF that follows the NCI, an exchange index tied to several crypto assets. It invests in ETH, BTC, Chainlink, and others.

It may also be useful to choose the best assets in each ETF and invest in them individually.

Principles

Do not take the risk of ruin: the risk of being knocked out of the game.

Do not violate these principles:

1. Greed, fear, and impatience cause losses:
   • Greed blinds and tempts you.
   • Fear takes away your courage and desire to act. It leads to inaction.
   • Impatience makes you decide without enough thought.
2. Humility: recognize that you are good at something, but that you can improve:
   1. Investors study every day. Be humble enough to recognize that you always have more to learn.
3. The knowledge trap:
   1. You grow and think you know a lot, but you actually know nothing. Humility frees you from arrogance.
4. HEVEL:
   1. Everything is “hevel,” an illusion. Even if you always do good and everything is in your favor, bad things can happen. Doing everything wrong can also lead to very good things. HEVEL speaks to injustice in general.
   2. Do not take life too seriously.
   3. Do not fear that your life will end. Fear that your life will never have begun.

Summary

The Holy Grail of Investing

1. Diversify your wealth across the three layers of diversification.
2. Find assets that are uncorrelated or negatively correlated.
3. Choose assets that are convex.

We are looking for returns in relation to risk. When you buy good companies, luck is on your side.