Diversification
Diversification involves holding a mixed variety of investments within a single portfolio.
What Is Diversification?
When it comes to building an investment portfolio, one of the most common risk management strategies that investors execute is diversification. Diversification involves holding a mixed variety of investments within a single portfolio. More specifically, a diversified portfolio contains a wide mixture of distinct investment vehicles and asset types. Diversification helps to limit overexposure to any one investment market — and its associated risk.
How Diversification Works
Investment portfolio holdings are typically diversified across asset types — though there are many cases where further diversification can be done within a single asset type. In theory, diversified portfolios should contain assets across markets so that the assets that are performing well outweigh any pressure felt as a result of those that are underperforming at any given time. After all, diversification is a hedge against unsystematic risk events that occur from time to time.
The reduction of risk in a diversified portfolio depends wholly on just how uncorrelated the held assets are. In practice, investors should seek to diversify a portfolio by acquiring assets that respond differently — preferably in an opposing manner — to any market influences that affect the current holdings within the portfolio.
Diversification by Asset Type
Though the investment world grows and evolves as new markets emerge, there have always been standard asset types that make up the average investment portfolio. These different asset types include:
Stocks — A type of security representative of shares or equity in a publicly traded company.
Bonds — Fixed-income debt instruments, typically offered by governments and large corporations.
Commodity Funds — Investments in globally demanded basic goods that perform independently of stock and bond returns.
Exchange-Traded Funds (ETFs) — A pool of securities that follows a specific index, commodity, or sector.
Real Estate — Investments in real property (land and buildings), natural resources, water and mineral deposits, livestock, and agriculture.
Cash and Short-Term Cash Equivalents (CCE) — Comprising most short-term, low-risk investments including treasury bills, money market vehicles, and certificates of deposit (CDs).
What is diversification in investing?
Diversification in investing is the practice of spreading out investments across different asset classes, industries, and geographic locations. This helps to reduce risk by ensuring that an investor's portfolio is not overly exposed to any one particular asset or market. By diversifying, investors can protect themselves from market downturns and other economic shocks. For example, if an investor has all their assets tied up in office buildings in downtown Chicago, and the next recession hits, they will be in for a world of hurt. However, if they own a mix of office, multifamily, retail, and industrial properties across multiple markets, they will be much better off. (Source)
What are the benefits of diversifying investments?
The main benefit of diversifying investments is that it can help protect your portfolio from market downturns. By investing in different asset classes and geographic locations, you can spread out your risk and be better positioned to weather economic recessions. For example, if you have all your assets tied up in office buildings in downtown Chicago, and the next recession hits, you'll be in for a world of hurt. However, if you own a mix of office, multifamily, retail, and industrial properties across multiple markets, you'll be much better off. Additionally, investing in multifamily properties early can help you diversify your investment portfolio. One of the main benefits of apartment investing is how relatively low risk the asset class is. If the market crashes, that may well wipe out your 401(k) — but odds are, your apartment buildings will be doing just fine.
For more information, check out 6 Ways CRE Investors Can Prepare for a Recession and The Pros of Investing in Apartments Early.
What are the risks of not diversifying investments?
Not diversifying investments can be a risky move, as it can leave you vulnerable to economic downturns. When all of your assets are tied up in one type of property or in one geographic location, you may be more exposed to market fluctuations. For example, if you have all your assets tied up in office buildings in downtown Chicago, and the next recession hits, you'll be in for a world of hurt. However, if you own a mix of office, multifamily, retail, and industrial properties across multiple markets, you'll be much better off.
For more information, please see this article.
What are the different types of diversification strategies?
When it comes to diversifying your CRE portfolio, there are a few different strategies you can use. The first is to diversify by asset type, such as office, multifamily, retail, and industrial properties. The second is to diversify by geographic location. This means investing in properties in different markets, which can help protect you from localized economic downturns. Finally, you can also diversify by adding another investor to help finance the purchase of an investment property. This allows you to buy a property with less money down, freeing up capital for other investments.
How can I diversify my portfolio?
When it comes to investing in commercial real estate (CRE), diversification is key. You can diversify your portfolio by investing in different asset types and geographic locations. This way, if one asset type or location is affected by a recession, you won't be as affected.
For example, if you have all your assets tied up in office buildings in downtown Chicago, and the next recession hits, you'll be in for a world of hurt. However, if you own a mix of office, multifamily, retail, and industrial properties across multiple markets, you'll be much better off.
You can also diversify your portfolio by keeping a diverse tenant mix. This way, if one tenant downsizes during a recession, you won't be as affected. It's often enough to have several tenants of varying sizes and in various industries.
What are the best ways to diversify my investments?
The best way to diversify your investments is to diversify your portfolio both in terms of asset type and geographic location. This will help you to be better positioned to work against headwinds. For example, if you have all your assets tied up in office buildings in downtown Chicago, and the next recession hits, you'll be in for a world of hurt. However, if you own a mix of office, multifamily, retail, and industrial properties across multiple markets, you'll be much better off. You can read more about different CRE asset classes and how they may fare in a recession here.
Diversification Within an Asset Type
As we’ve mentioned before, diversification can also be done among investments within a single asset type — most commonly done with stocks. For instance, an investor may acquire stocks from different or opposing sectors that have historically had a low return correlation. In some cases, diversifying a stock portfolio can be as simple as investing in stocks within the same sector that have different market capitalizations.
In real estate, diversification can mean many things. Sometimes, simply holding assets from different regions can be enough to provide a high tolerance to risk. Many investors, however, take things a step further by finding two or more different real estate sectors to hold in a portfolio — often combining things like retail properties with multifamily, or self-storage facilities and office properties.
There is always a plethora of different bonds investors can select from, like U.S. Treasuries, high-yield bonds, and more. Similarly, ETFs may be pools of similar securities within a sector, but well-placed ETF investments across multiple sectors can significantly reduce an investor’s level of exposure. In any case, each asset type has a unique market that can often be explored for further diversification purposes.
Advantages of Adding Self-Storage Facilities to Your Investment Portfolio
Self-storage is considered a relatively safe investment option for those looking to diversify their portfolios. Rented out on a monthly basis, self-storage facilities generate continued and steady cash flow. While tenant turnover can be high, a self-storage unit can be cleaned in 20-30 minutes and leased quickly after its vacated, thanks to high demand across the country. The need for storage is driven by the “four Ds”: death, divorce, dislocation, and disaster; therefore, the sector performs well even in downturns, in contrast to other asset types such as office, retail, or hospitality. The self-storage sector also has low foreclosure rates, making it a comfortable asset class for lenders as well.
Disadvantages of Diversification
While diversification has been a long-employed investment strategy, it isn’t without its drawbacks. For instance, managing a portfolio with multiple holdings across sectors can be substantially more time-consuming and expensive than managing a portfolio with less-diversified holdings. Typically, the added expenses can be attributed to transaction fees and brokerage commissions associated with the buying and selling of a multitude of different assets — which, of course, with due diligence factored in, can be a tedious and drawn-out task.
Also worth noting, the very benefit of reducing risk also works against returns. The more spread out investments are — meaning less capital in any one investment — the less of a return that can be received from each individual investment. To illustrate this, imagine $100,000 invested equally between five stocks, and one of the five triples in value. That $20,000 investment is now worth $60,000 — but if the entire $100,000 was invested in that single stock, it would be worth a whopping $300,000.
Diversification can only provide a reasonable buffer against risk by limiting focus — which can, at times, limit returns when a market undergoes considerable growth.