Diversification is just a fancy name for the saying: “don’t put all of your eggs in one basket.”
Diversification is when you invest in many securities, and most investment professionals agree that diversification is the most important component of reaching long-range financial goals while minimizing risk.
What is a portfolio?
Investors refer to a person’s collection of investments as a “portfolio.” If you own stocks, bonds, and rental properties, that’s what your portfolio consists of. Your portfolio might be further divided into sub-asset classes like large-cap stocks, mid-cap stocks, small-cap stocks and international stocks. Ideally, a portfolio should hold a variety of investments, not all of which are highly correlated to each other.
Why is diversification important?
Many factors that change in real-time affect the price of stocks, bonds, and alternative assets: individual company events, industry trends, world occurrences, government actions, among others. This is why diversification is a powerful weapon against risk. By allocating investments among various financial instruments, industries, and other categories, it helps maximize return in different areas that would each react differently to the same event.
There are different forms of diversification; you can diversify both among and within different asset classes. When you diversify within asset classes, you divide the money you’ve allocated to a particular asset class among various categories of investments that belong to that asset class. Stocks are one asset class, bonds are another, and real estate is another. This form of diversification is common among the wealthy– but you don’t have to be wealthy to diversify.
The benefit of Investing in different asset classes is best demonstrated by the Yale Endowment. The Yale Fund has boasted one of the most successful institutional track records over the last 20 years.
In 1985, 80% of its endowment dollars were in stocks, bonds, and cash; and over time the fund dropped that down to 10% of the portfolio
Today, 90% of the endowment is now in non-traditional asset classes that are illiquid resulting in pricing that does not fluctuate with the stock market and leads to higher expected returns.
The Yale fund made a conscious decision to minimize the role of stocks and bonds in its portfolio and diversified into alternatives like real estate and private equity investments.
David Swensen, the manager of Yale University’s $27 billion endowment fund, strongly supports the concept of portfolio diversification. Real estate is one asset class Swensen recommends investors allocate anywhere between 15 and 20% of a portfolio into. Since real estate responds to different market forces than stocks or bonds, this insulates a portion of your portfolio from market corrections and crashes. In his book “Unconventional Success,” Swensen states that real estate risks and returns fall somewhere between those of bonds and equities.
Diversification in Real Estate
Owning real estate investments remains one of the most effective means of growing wealth. Unlike traditional investment vehicles such as stocks, real estate is not tied to the stock market or the market fluctuations in major financial centers. Real estate is also the world’s oldest asset class. For centuries, real estate ownership has been the hallmark of the wealthy and elite in most societies. Stocks weren’t even invented until 1602 by the Dutch East India Company and to this day, real estate continues to make large numbers of millionaires, perhaps more than any other asset class.
Since real estate is a tangible investment asset, it is more dependent on the local market. Therefore, in many areas, when the value of stocks and other traditional assets decline, the value of real estate investments may actually rise.
In fact, if you look over the last 30 years, you can see that real estate has beaten the stock market by a significant margin.
If there is one thing that remains the top priority for all investors, it’s having a well-diversified portfolio. Real estate investment can play a vital role in optimizing portfolios.