You have probably heard from many financial advisors that diversified investment portfolios have been proven to yield the best returns over the long term. But what is a investment portfolio diversification and what strategy should you take to achieve it?
Risk Management with Portfolio Diversification
One of the biggest factors that you need to consider and understand when looking at investment portfolio diversification is risk. Risk takes many forms, but in short, it is essentially the likelihood of unexpected losses for any type of investment.
It can be relatively simple to look at the historical performance of an investment and project over the next year, five years, ten years, etc. But when we do this, we need to consider that the future is not likely to be exactly what has happened in the past. Many events occur that can have catastrophic impact on investments. The financial markets crash, the terrorist attacks of September 11th, 2001, and the recent COVID pandemic are all events that caused huge unforeseen losses for many investors.
Portfolio Diversification Strategies
One of the best strategies to avoid risk is to place multiple investments across several different asset classes, different industries, different companies, and different geographies. This allows an investor to absorb losses in one investment that may be uniquely impacted by negative, unforeseen events, while preserving values in other investments.
In other words, if you have all your eggs in one basket, and you drop that basket, you are going to lose all your eggs. If you have all your eggs spread out over many baskets and one, or two, baskets get dropped, your other eggs will all be safe. For many investors, this means allocating a certain portion of their investable capital into things like stocks, bonds, cash, and alternative investments like commodities and real estate.
But how much should you invest in each asset class and how do you execute on this? There are many schools of thought on asset allocation, and you should consider things like your liquidity needs, your age, and your willingness to accept risk and volatility in your portfolio, so there is no “one size fits all” allocation that works for all investors.
For example, a portfolio with 55% stocks, 35% bonds, and 10% real estate has historically outperformed a 60% stock/40% bond portfolio with only slightly more volatility while matching the returns of an 80% stock/20% bond portfolio with less volatility. But even after you determine the right portfolio diversification for yourself, you will need to have a team of experts who help you allocate your investments in each of these categories.
A registered investment advisor will give you advice and access to a broad spectrum of securities, bonds, and other publicly traded investments. But for real estate, investors often struggle to find the right way to access investments that allow them to diversify sufficiently into that asset class without taking too much risk, getting charged excessive fees, losing control of your investment, taking on too much management responsibility, or venturing into an investment they know little about.
Real Estate Portfolio Diversification
Real estate is often a go-to diversification tool. This is because it is uncorrelated to the stock market and many other traditional investment types. This makes it an excellent tool to mitigate risk for stock and bond heavy portfolios.
However, there are several real estate investment options to choose from.
Real estate investment trusts (REITS). REITS operate much like real estate stock. The advantage is that they are very liquid, however investors have no discretion over what real estate is purchased and fees can be very high.
Direct purchase. Buying investment real estate directly avoids fees, and gives you complete control, but it can come with a ton of management responsibility that can take up all your time. This type of investment often takes a large amount of capital, reducing the average investor’s ability to diversify.
Private equity real estate. Private equity real estate is a great middle ground option. Sophisticated real estate managers identify properties for purchase and open up investment opportunities to accredited investors to join in those investments. This limits the investor risk to only the capital they have invested (no loan guarantees), gives them discretion to select the properties they want to invest in and pass on those they do not like as much, and takes away all the management hassles.
Hiring a Real Estate Investment Manager
When you are looking for qualified real estate investment managers, you should consider their strategy:
- What types of properties do they purchase (office, retail, industrial, multi-family, etc.) and what are the forecasts for each of those asset classes?
- Are they building new properties or are they purchasing existing stabilized properties? New construction can often come with more risk tied to construction costs, short term financing, and speculation on market cycles.
- What geographic markets are they in and what is happening in those economies?
- How are they financing the purchase? Are they borrowing too much against the investment or are they balancing debt with real equity that will withstand a downturn in the market?
Multifamily Real Estate Investing with CEP
CEP Multifamily has a 20-year track record of identifying core-plus multifamily real estate investment opportunities that drive cash flow and asset appreciation while limiting risk through preferred financing terms that protect investors from the cycle of real estate markets while capitalizing on the long-term return opportunities presented by the unique economies of the Pacific Northwest. For more information on real estate investments sponsored through CEP Multifamily, please click here.