Most investors have heard the cliche from a wealth manager at some point: “Investing 101: Diversification is the most important factor to get the best returns.”
Or in other words, ‘Don’t put all your eggs in one basket.’
A well-diversified investment portfolio is key to lowering the amount of risk you carry as an investor.
HOW DOES A DIVERSE INVESTMENT PORTFOLIO LIMIT RISK?
All investments carry some amount of risk. Owning stock in a business puts you at risk if the business performs poorly or goes bankrupt. Personally owning real estate creates risk for you if the property is damaged or devalued, though you could mitigate that risk with real estate syndication.
A diversified portfolio allows you to spread your investing risk across multiple asset classes. If one asset class performs poorly over a given time, it won’t be able to drastically affect a diversified investment portfolio because the other assets held strong.
The importance of diversification is best demonstrated with an example:
Investment Portfolio ‘A’ has $100,000 of capital and is invested evenly across two different assets: ‘Asset Y’ and ‘Asset Z’.
Investment Portfolio ‘B’ has $100,000 of capital and is invested evenly across twenty different securities: including both ‘Asset Y and ‘Asset Z’.
As the year goes along, the market for ‘Asset Y’ holds steady and it doesn’t lose or gain any value. On the other hand, ‘Asset Z’ was a company that lost their competitive advantage and the outlook is bleak. By the end of the year, ‘Asset Z’ declares bankruptcy and shareholders are left holding worthless shares.
Now assuming all other investments remain constant, how did the two investment portfolios perform? Did the more diversified portfolio ‘B’ perform better than ‘A’?
Investment Portfolio ‘A’ lost the entire investment in ‘Asset Z’, and the remaining capital is $50,000.
Investment Portfolio ‘B’ lost the entire investment in ‘Asset Z’, but the remaining capital is $95,000.
Bottom line: Because Investment Portfolio ‘B’ spread the investment risk across twenty different investments, suffering a catastrophic loss on one investment doesn’t severely harm the entire portfolio.
Asset allocation is the next step. Asset allocation is choosing which asset classes to invest in (i.e. stocks, bonds, gold & silver, real estate, cash, etc.), and how much capital to invest in each.
The amount of capital you invest in each asset class is up to you. We’re going to discuss why real estate is a crucial asset class for all investors, and how you can use real estate private equity as an effective vehicle for your investment diversification.
Why You Should Invest in Private Equity Real Estate
Private equity real estate investments are a strong way for you to diversify your investment portfolio. They differ from stocks and bonds in various ways that make them an attractive asset for investment.
Real estate is commonly viewed as a lagging economic indicator, giving it a low correlation to the performance of stocks and bonds. Real estate values and prices are affected by different factors, which is what you want from your diversified investments.
Another advantage with real estate is the potential diversification within real estate markets themselves. Different factors affect property prices in different areas, allowing for investors to potentially diversify their real estate risk across several markets.
Investopia shows that average 20-year returns in commercial real estate outperform the overall stock market. Here is the breakdown of 20-year average returns for stocks, bonds and real estate in the U.S.:
- S&P 500 Index average return: 8.6%
- 20-year Treasury note yield: 2.67%
- Diversified real estate investments: 10.6%
Potential Tax Benefits
Real estate investments offer investors potential tax benefits to alleviate the burdens of capital gain taxes. 1031 exchanges give investors a mechanism for deferring all capital gain taxes by reinvesting the capital in another property.
If you invest in private equity real estate, you may be able to channel your profits from one sale into the next tax-free.
IRC Section 1031 states: “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”
The benefit of deferring capital gain taxes follows the same concept of deferred taxes in a 401k. By deferring taxes, the investor can maximize the amount of capital to reinvest in future real estate investments.
More capital to reinvest equals more compounding of returns on your investments.
Real estate provides investors a tangible asset to own. When you own equity in a property, you don’t own an ‘I Owe You’ written on a piece of paper like a bond. You own a physical, tangible property.
From an investor’s perspective, tangible assets provide a valuable asset class to hedge against inflation or changes in a currency’s purchasing power. Tangible assets always have some economic value that’s reflected in price as currencies fluctuate.
In the U.S., the Federal Reserve reports the dollar’s purchasing power has decreased about 96% since their creation. Real estate gives you a buffer against the dollar’s declining value in your portfolio.
You can be a passive investor when it comes to private equity real estate deals. Investors don’t need extensive experience in the real estate market to generate returns with their investments.
Many investors are green when it comes to the real estate market. Investors can leverage a real estate investment company's professional skills and expertise in identifying and executing real estate opportunities.
How You Can Invest in Real Estate
Most investors look at real estate investments and all they see are problems:
- “I don’t have the experience or expertise to manage a real estate project.”
- “I don’t have all the capital to fund that project.”
- “I don’t have time or effort to give to a real estate investment.”
- “There is too much risk in real estate projects.”
- “I have no clue where to start.”
Fortunately, there are plenty of ways for everyday investors to use real estate private equity and diversify their portfolios. One easy way is through real estate investment companies that facilitate real estate syndication.
Real estate syndication allows multiple investors to pool their capital together and channel it into real estate projects. Investors gain the advantage of exposure to real estate opportunities they wouldn’t otherwise be qualified for.
If you’re an investor who has been looking to add real estate assets to diversify your investment portfolio, real estate syndication can provide the investing mechanism to do so.
(header image source: Keven Harris)