Legendary investor Warren Buffett has words of wisdom for anyone trying to get the most out of a long-term investment strategy. Diversification, he likes to say, is “protection against ignorance.”
All investors are ignorant about plenty of different markets, and according to this philosophy, spreading money around is a good way to follow the smart money. (At last count, the “Oracle of Omaha” had a net worth north of $100 billion.)
Diversifying an investment portfolio can reduce risk and maximize returns. Diversification means investing in multiple asset classes, including real estate, stocks and bonds. (Credit: Getty Images)
What is the definition of diversification?
Diversification is a risk management strategy, which calls for investing in various asset classes to mitigate exposure to loss and maximize earning potential. (We’re doing our best to not trot out the old metaphor of putting all your eggs in one basket, but honestly, it’s a little tough to avoid.)
But diversification goes beyond investing in a portfolio of diversified U.S. and international stock funds, which most professional advisors recommend, since all that money is still in the equities market basket.
This is where real estate comes in.
For some investors, a portfolio with at least 20 percent invested in real estate feels right, while others will opt for a higher percentage, in some cases 50 percent or more, because they believe they are better at picking homes or commercial properties than at picking stocks. And many like the security that comes with a tangible asset, like a house or a building.
Real estate’s role in managing risk
With home prices popping in many markets across the country, it’s no easy task to find deals that will offer cash returns and appreciation so investors need to do their homework.
Or consult with experts.
“It’s highly competitive,” says Don Ganguly, senior vice president of Mynd investor services. “It’s going to require grit and persistence to get a deal done in the parameters you can afford.”
Interested investors can start their search with Zillow, partner with a local agent, or consult Mynd, an end-to-end real estate investment technology platform for investing in single family residential (SFR) properties.
“Investing in single family real estate allows you to be a bit granular, to take it one home at a time. Then you can expand and get up to 10 properties with the low interest rate,” Ganguly says. “We look at 25 markets and give investors information on data like pricing and returns on investment, and we have investment location managers who will help you take a deal over the finish line.”
Investing in real estate, especially single family residences, brings numerous benefits, such as substantial tax advantages, government-sponsored leverage, and cash on cash returns, defined as a property’s cash return from rental income against cash invested.
Once the investor graduates from a starter investment into more than one property, it’s wise to diversify into various markets to benefit from increases in home prices in one particular city while insuring against a downturn in other geographic areas. Mynd can serve the investor as a partner in 25 U.S. markets, from Atlanta to Austin, from Phoenix to Raleigh, from Las Vegas to Charlotte.
Real estate and bonds are an effective strategy
To further diversify, one can add bonds to a portfolio, which usually offer lower returns than stocks but are also much lower-risk. Depending on the investor’s age and risk tolerance, different balances of stocks and bonds are appropriate.
Real estate is considered low risk as well. But many American households are not invested in real estate apart from their homes, if that. Single family homes have seen high demand and chronic undersupply since the Great Recession of 2008, driving up values and returns for those invested in single family residential (SFR). What’s more, mortgage interest rates are lingering at historic lows, allowing investors to very favorably leverage their investments.
Sam Dogen, who writes the blog Financial Samurai, points out that per Census Bureau data, at the end of 2020, not even two-thirds of households owned their homes. That means about a third of the U.S. missed out on the post-2010 housing boom, he writes. What’s more, he observes that among homeowners, almost all of the average American’s worth is tied up in their residence.
Two types of perils that investors face
Investing is, by definition, always a game of prudently trading off risk versus return. Diversification can address some of these, but no strategy can outrun every risk.
What are the different kinds of risk? They go in two buckets.
Systematic risks are those that occur throughout a financial system and are unavoidable. For example, rising inflation or interest rates hit all industries. But there are ways to manage this risk to some degree, for example by buying commercial real estate or fixed-income assets like bonds.
By contrast, idiosyncratic risk is avoidable, and diversification manages this risk effectively. Examples of assets that have idiosyncratic risk are shares in a particular company — whose fortunes may rise or fall — or in a wider industry, like the energy sector or the auto industry.
Yale 's chief endowment officer diversified the university's portfolio into real estate, as much as 20 percent in some years. (Credit: Yale University)
Yale endowment’s real estate strategy sets the bar
Investment firms wanting to maximize their returns often look to Yale University’s endowment, which earned an impressive 13.2 percent annual return between 1985 and 2015, and was insulated from downturns during that span.
Under chief endowment officer David Swensen, Yale diversified beyond traditional assets, such as publicly traded stocks, into alternative investments, which are privately traded and are correlated at low levels to traditional assets. Over that period, the endowment’s investment in public market asset classes dropped from more than 80 percent to less than half. Notably, those included a healthy investment in real estate, as high as 20 percent in some years.
“People used to think of real estate investments as one step above bonds,” Rohan Parikh, real estate team leader at New York’s Altfest Personal Wealth Management, told Mynd. The general assumption was that stocks were what would really grow a portfolio. But Yale’s success devoting so much to real estate changed some people’s minds.
Others say that not everyone has learned the lessons of Yale.
“I think the Yale endowment model has as much misled investors as guided them correctly,” says Michael Rosen, chief investment officer at multi-asset firm Angeles.
Founded in 2001, Angeles has offices in New York and Santa Monica, California, and its 27 investment professionals oversee about $6.3 billion in outsourced investment management and over $38 billion in consulting relationships.
“Yale has significant material advantages that very few investors have,” Rosen says. “It’s not quite so simple for investors to replicate what Yale has achieved simply by following their asset allocation model.”
Indeed, individual investors’ profiles differ starkly from those of a university, not only in time horizon but, obviously, in scale: Yale’s endowment measured more than $31 billion at the end of fiscal year 2020.
But Swensen also created a model for individuals, which dictates that they should put at least 20 percent of their portfolio into alternatives such as real estate.
Why real estate acts as an inflation hedge
“Real estate is a great asset class to diversify into,” says Parikh.
His firm, which has been in the business for over three decades, has a team of 40 that manages $1.5 billion in assets for 650 client households.
“One of the reasons for this is that historically, real estate has been independently correlated with stocks and bonds,” says Parikh. “That in itself is a really good reason.
“Another is that it’s a good inflation hedge,” he adds. “If you have a single family property that you’re renting out, your rent goes up as inflation rises. Or, say you’re holding it for yourself. The value appreciates over time as inflation goes up.”
With inflation hitting a high of 6.2 percent annually in November, the time to put some cash in a more stable asset like real estate is now.