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How to Enhance Portfolio Diversification Using Real Estate – by Fundrise

All investment portfolios – even the strongest – are likely to hold investments that will experience some periods of loss. However, by diversifying your portfolio holdings, you can mitigate those losses, which can boost your portfolio’s return potential. But not all diversification strategies are created equal, which makes choosing the right diversification strategy crucial to your investment success.

Most investors understand the risk that comes with investing in a single stock, asset type, or industry. But what about the risk that comes with investing in only one market? Many investors are diversified across and within asset classes, sectors, industries, and more – but, usually all within the stock market, which is a public market. With the public market shrinking, and ownership of stocks becoming more consolidated, investments traded in the stock market are becoming increasingly correlated. With this, meaningful diversification is getting increasingly difficult to achieve in the public market alone.

Wider accessibility to private market investments offers individual investors new options outside of the stock market. Private market real estate, in particular, is far more accessible now than it has ever been. Easy accessibility, together with the benefits of low correlation with the stock market, a history of long-term appreciation, and the potential for regular income, can make real estate a powerful diversifier for your portfolio.

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What Make an Investment Portfolio Diversified?

Diversification is used to reduce the risk of loss, which ultimately can improve the stability and return potential of an investment portfolio. When risk is reduced properly though diversification, its volatility is reduced. With lower volatility, an investment portfolio is more stable, and its return earning potential more predictable. Rather than being forced to ride the waves of market cycles, investors are able to enjoy the peace of mind that comes with having their investments live on quieter waters.

So, what does a diversified portfolio look like?

There are many diversification strategies to choose from, but strong ones generally try to maximize a portfolio’s risk-adjusted returns. In other words, you should try to invest in assets that offer the highest possible return at your given risk level. By investing in assets with low or no correlation, you can reduce unnecessary risk in your portfolio.

When investments are correlated, they share some or all of the same set of risks. So, if one investment experiences a loss, then a correlated investment is also at risk of loss. On the other hand, if your portfolio holdings are spread across uncorrelated assets, the performance of one or more investment could mitigate losses in your portfolio when another asset underperforms. This is because uncorrelated assets are far less likely to lose value in tandem than correlated investments.

The 20% Rule

The 20% rule is a leading diversification strategy, which was created by the Chief Investment Officer of the Yale Endowment, David Swensen. The 20% rule aims to reduce portfolio risk and in turn maximize return potential by allocating at least 20% of an investment portfolio toward alternatives – an asset class with low or no correlation with traditional, publicly-traded assets. Alternative investments are investments that fall outside of the classification of traditional investments, and are generally traded in the private market. Following the 20% rule, private market investments are becoming increasingly crucial to investment success. Institutional investors have a longer history of diversifying into alternative with pensions and endowments allocating 28% and 52% of their portfolios respectively to alternatives.

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How Real Estate Can Enhance Portfolio Diversification

The private market experiences very different buying and selling dynamics than the public market. Let’s look at the attributes of private market real estate and how this asset class can be a powerful complementary diversifier for a portfolio of traditional investments.

Separate Markets with Low Correlation

The biggest difference between private market real estate and traditional investments is that they trade in different markets. Traditional investments, such as stocks, bonds, and commodities, trade in the stock market, whereas private market real estate trades in, as you may guess, the private market. Public market investments each have their own individual sets of advantages and disadvantages, but because they’re traded in the same market, they share the same marketwide strengths and weaknesses. And, because private market investments are traded in a separate market subject to different driving forces and structural features, they don’t share the same wide risks as public investments. Therefore, private market real estate has a low correlation with traditional investments at the market level.

For instance, expectations of future interest rate hikes (or actual hikes) typically cause the stock market to decline, because higher interest rates can reduce both business and consumer spending. Similarly, expected or actual rate hikes can have a depressing effect on publicly traded real estate investment trust (REIT) share valuations, because higher interest rates reduce the risk-free to capitalization rate spread thereby driving down real estate values.

By contrast, expected or actual shifts in the interest rate environment should have minimal impact on an investor’s equity stake in a commercial real estate asset as long as the senior debt financing secured for that investment is a long-term loan with a fixed-rate. In fact, an interest rate hike could make the asset more valuable, because it now offers an interest rate hedge, and stands to benefit from the likely positive macroeconomic market conditions that typically precede federal interest rate hikes.

Distinctive Investment Structures by Market

Coupled with low correlation at the market level, the performance of private market real estate has a low correlation with the performance of public market investments at the asset class level. Although real estate is traded in the public market through REITs, private market real estate investments are structured in a wholly different manner. REITs themselves are structured differently in the private market, whether private REITs or public non-traded REITs, which gives REITs different diversification potential based on the market in which they’re traded.

In general, these different structures carry different sets of risks, fee structures, return structures, and varying return potential. Therefore the differences in investment structures between public and private market vehicles further reduce the correlation between private market real estate and traditional investments.

Differences in Access to Liquidity

One of the biggest benefits of public market investments is the high level of liquidity that they offer. Shares of stocks and bonds can easily be bought and sold on a daily basis. Because of this, public market investments offer a high degree of flexibility.

However, it’s important to note that this access to daily liquidity comes at a price. The liquidity premium is a built-in cost, which is innate to public market investments. Investors pay whenever they buy an investment. For long-term investors who follow the “buy-and-hold” strategy, this can be an expensive feature that goes largely unused. Those who are building a portfolio to support their retirement plan are usually long-term investors, who should likely lean more toward long-term investments. Avoiding costly features that go mostly unused while building the most stable and reliable path to retirements saving possible are key.

Private market real estate, on the other hand, is generally illiquid with return potential maximized over time through rental income and/or appreciation. Liquidity options for both public and private investments each have their advantages and disadvantages, but their differences can make private market real estate a good fit for long-term investors, as well as powerful complementary diversifiers for investments with shorter investment horizons.

Market Efficiency Mean a Lot for Investors

The public market is highly efficient with prices set by the market. Information concerning public investments is widely disseminated, which makes it difficult for one party to gain more information than the other party on an investment. Transaction costs are also low, which results in more frequent buying and selling. In fact, more than a billion shares are publicly traded each trading day.

In contrast, the private market is highly inefficient. Buying and selling private market real estate generally comes with higher transaction costs, and with fewer buyers and sellers participating. These differences in buying and selling dynamics in the private market offer another diversifying element for investors largely invested in the public market.

While these conditions may seem unfavorable, they are actually potentially more favorable to investors. That’s because whereas the market sets prices in the efficient public market, there’s room for negotiation between the buyer and seller in the inefficient private market. With fewer buyers and seller participating in the market, and with information unequally shared, the market doesn’t necessarily set the price of the asset, giving investors a greater chance to “beat the market” in a way that isn’t possible to do on a consistent basis in the public market.

Essentially, limited competition on the buyer’s side in private markets gives those with the necessary knowledge, skills, and resources a competitive advantage to earn above-market returns, or alpha. An investor who holds common stock in a publicly-traded company doesn’t have the ability to earn outsized returns because they have more knowledge, resources or skills than another common-stock holder. An investor could spend hours daily researching Apple, but this would likely not change their return potential from their Apple shares. In other words, your returns will be the same as those earned by any other shareholder with the same class of stock who buys and sells those shares at the same time.

Jung Min-seo

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