The Key to Investing, Not Speculating

Last week, there was significant uproar in Colombia about the losses sustained by private pension funds during the first quarter. The alarm was raised by the clients themselves who were shocked to see negative returns on their savings. Baffled, they began to share photos of their statements on WhatsApp, showing the losses and demanding explanations of what was happening. Within a couple of days, the news had spread across all media, and the president of Asofondos had to step forward to provide explanations. These explanations were quite straightforward: international markets took a downturn in February, impacting Colombian households directly.

When I first read the news, I dismissed it almost immediately, viewing it as yet another example of collective hysteria amplified by social media. Anyone familiar with the markets knows that this kind of thing happens, that returns are not always positive, and that part of the investment game is having the stomach to withstand the vertigo of the falls. However, upon further reflection, I realized that the clients who demanded explanations did the right thing, and we can all learn a bit from their assertive attitude. Often, we are not inquisitive enough about financial matters and let others make decisions for us. It is far better to be vigilant about what is happening with our savings and investments and to demand explanations without embarrassment whenever something is unclear.

Someone might go beyond the explanation provided by Asofondos and ask why were Colombian pension funds investing in international markets? One could easily construct a nationalist argument highlighting the importance of investing domestically and how noble it would be to keep those resources in Colombia to benefit other sectors of the economy.

Allocating part of a fund’s resources abroad is based on one of the basic principles of long-term investment: diversification. This might sound like one of those vague and inconsequential concepts from economists, yet for me, it is definitely the key that separates real investors from speculators. A well-diversified portfolio allows for a sound investment strategy that yields positive but realistic returns. Without diversification, you’re essentially letting luck handle your money.

While one can define diversification very precisely, it’s much easier to illustrate with examples: Investing in 10 technology companies is less diverse than investing in 10 companies each from different sectors (e.g., one in technology, another in energy, another in industrial products, one in healthcare, etc.). Investing only in Colombian companies, or only in American ones, or only in European ones, is less diverse than investing simultaneously in companies in Colombia, the United States, and Europe. There is no exact rule that determines the number of companies needed for proper diversification, but generally, more than about 20 and fewer than about 100 are required to capture all the benefits.

The concept of diversification extends beyond the stock market. Investing only in corporate stocks is less diverse than investing in both stocks and bonds. For those in real estate, investing only in houses and apartments in a single neighborhood diversifies less than investing across various parts of the city. Even in non-traditional investments, the concept applies. A perfectly respectable investment vehicle is high-quality wine, and one diversifies less by investing only in Bordeaux than if one also invests in Burgundy, Tuscany, and Rioja.

A fully diversified strategy goes one step further and simultaneously invests in the stock market, fixed income, real estate, startups, wines, and basically any type of asset that can yield a return.

The strategy of diversification originated from the work of Harry Markowitz in the 1950s with his Modern Portfolio Theory and completely transformed how we understood the world of investments. His conceptual framework lifted the obscurity of how people thought about and acted with money and provided a scientific approach without which we would still rely on myths and fables to determine our future.

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