What is Diversification in Investing?

What is Diversification in Investing?

To put it simply, diversification means spreading your investments across several asset classes to reduce your exposure to any one sort of asset . This strategy is designed to help you reduce the volatility of your portfolio over time.

What is the importance of diversifying your portfolio with Real Estate? 

We cannot predict the future, but if we refer to historical data, we have learned that corrections and recessions occur in cycles. So just because we are currently not experiencing one at the moment, it doesn’t mean that it will not happen in the not so distant future. At the same time, if we are experiencing a recession, a recovery will certainly be just around the corner  

Diversification is one of the most effective tactics for maximizing your portfolio’s long-term growth. You may consider diversifying your portfolio by adding real estate investments.  Additionally, you may diversify your real estate portfolio and reduce your overall risk by investing in a mix of real estate assets.

Let’s look at the top five techniques of diversifying your real estate portfolio and preserving your assets.

  1. Asset Type Diversification

One of the things that makes real estate investing so distinctive is the range of assets available. You can choose from investing in single-family houses, modest multifamily buildings to major apartment complexes. Retail, industrial, office space, self storage, and other types of investments are also available.

In all asset classes, there is value to be added and money to be made. You may protect yourself from bigger macroeconomic shifts by diversifying your assets, such as the shift we’re witnessing in the retail space with the rise of ecommerce or the transition away from physical office spaces in favor of remote work.

  1. Increasing Geographical Diversification

Real estate is hyperlocal, which means that while one city can be thriving, another might be slowing down. You can profit from the ups and downs of multiple markets while also hedging your bets against a significant market correction by diversifying across several geographies.

If all of your real estate holdings are concentrated in one market, and that market experiences a downturn, your entire portfolio could be jeopardized. If you had one investment in Dallas, another in Orlando, another in Charlotte, and so on, the overall impact on your portfolio would be much smaller.

Look for markets with substantial job growth, population growth, and job diversity when diversifying across geographies. This will assure that the market you’re investing in will continue to grow strongly in the years ahead.

  1. Asset Class Diversification

It’s crucial to know a little about human behavior during booms and crashes when diversifying across asset classes. Let’s examine apartments as an example. People would normally like to rent larger, more opulent apartments in nicer regions during boom times; however, in difficult times, people would inevitably need to downsize, find a more affordable apartment or relocate across town.

Asset classes that do well in both good and difficult times do exist. Because real estate is cyclical, and no one knows when the next recession will strike, diversifying your portfolio across asset classes is critical to ensure that your portfolio remains profitable throughout the market cycle.

  1. Diversifying by Strategy and Keeping it for a Long Time

Changing up your investment strategy and holding duration is another effective method in diversifying your portfolio. While one rental property may be a good buy-and-hold investment, another may be better suited to the BRRRR plan (buy, rehab, rent, refinance, repeat). Even within a single geographical market, diversifying by investment technique could be a useful method to protect against a slump.

In terms of hold time, due to market conditions or your investment strategy for particular properties, you may have a shorter horizon on certain properties and expect to sell in a year or two. On the other hand, other possessions may have a longer time horizon and can be held for many years or even passed down to the next generation.

  1. Active vs. Passive Investing Diversification

Finally, incorporating a mix of active rental properties and passive real estate syndications (group investments) into your portfolio can help it diversify.

Passive syndication investments are typically larger commercial assets like apartment buildings, whereas rental investments are typically the smaller residential properties.

While maintaining your own rental properties and business plan, syndication allows you to profit from skilled syndicators’ experience and track record, which can sometimes bring new ways and markets to your portfolio.

Real Estate Investing Versus Stocks and Bonds

Which produces better returns?

You may decide to invest in real estate to diversify your portfolio, but what about the returns? Over lengthy periods of time, which asset type has delivered superior returns: real estate or stock investing?

To begin, it’s worth noting that stocks have the tendency to have value increase faster than real estate. An S&P 500 index fund has typically delivered total returns of 9–10 percent over long periods of time. Real estate prices, on the other hand, tend to surpass inflation, but only by a small margin. 

Since 1940, the median home value in the United States has risen at a 5.5 percent yearly rate. However, this is deceptive. On average, today’s homes are far larger than they were in the past. In 1940, the typical home was 1,246 square feet, nearly half of the 2,430 square feet average in 2010. When home size is taken into account, the yearly rise per square foot reduces to 4.6 percent. The average home value has only increased by 1.5 percent per year after accounting for inflation.

If we compare it to stock returns, this is a win-win situation. After accounting for inflation, stocks have produced an annual return of around 7% over the long term. To put it another way, the stock market has outperformed the real estate market by more than four times. This is most likely why you’ve heard someone say that “your home isn’t an investment.”

Real Estate as an Investment has a Much Stronger Return Potential

While real estate prices rarely keep up with inflation, there are a few reasons why real estate investing still performs better.

  1. Leverage

Unlike stocks, where borrowing money is considered irresponsible, you may use big sums of financed money to invest in real estate without taking on a lot of risk.

Lenders frequently finance investment homes with down payments as low as 20%–25% of the purchase price. The down payment requirements for a primary residence can be much lower (although you may have to pay mortgage insurance with less than 20 percent down).

Small returns can be dramatically increased as a result of this leverage. Consider the following simplified mathematical illustration. Let’s imagine you pay $100,000 in cash for an asset that improves in value by 3%. Your investment yielded a $3,000 (3 percent) profit.

Let’s imagine you purchase a $500,000 asset by investing $100,000 of your own money and borrowing the remaining $400,000. If the asset’s value rises by 3%, you’ll get a $15,000 return, or 15% of your $100,000 investment.

  1. Renting Out for Passive Income

The ability to rent out investment properties to create passive income is the second reason why real estate investments can yield high returns. One of the finest methods to create passive income in real estate is to rent out investment properties. For example, you recently purchased a triplex as an investment property. It would be ideal if the value of the property increased over time. However, the rental revenue from the three flats is expected to be the main driver of your profits.

  1. Tax Advantages 

Finally, real estate investors benefit from tax advantages that are not available to stock investors. When you buy an investment property, for example, you can write off the purchase price over a set number of years, which is known as depreciation. It would be fantastic if you could depreciate your stock investment in the same way, but that isn’t possible.

As you can see, the mix of rental income, leverage, and tax advantages can result in a long-term investment strategy with favorable returns.

Conclusion

Let’s discuss a real life scenario. You started a business and invested your money there to set it up and let it run. With all the ups and downs you went through as a start-up, your business managed to survive and after some years, you finally reached the stage where you can confidently say that your venture is stable and earning steady income.  

Logically speaking, the ideal thing  would be as you build up your wealth, the more diversified you should be. Once you’ve reached retirement age, a large portion of your portfolio should be invested in more stable, lower-risk investments that can generate income. Even in retirement, diversification is essential for risk management. 

Aside from stocks and bonds, it has been proven that real estate investment is  effective in growing your income continuously for years to come. Knowing five techniques of diversifying your real estate portfolio is a good start.  

And if we should compare which has greater returns between the two, it is a bit difficult to compare them on an apples-to-apples basis but as pointed out, real estate investments have just as much, if not more, return potential than stock or bonds. When you consider the potential for price increase, rental income, and the inherent tax benefits of real estate investing, you can expect to see outstanding long-term returns.

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Reference Links: 

https://theinvestorsbook.com/real-estate-investing.html

https://www.stessa.com/blog/how-and-why-you-need-to-diversify-your-real-estate-portfolio/

https://www.millionacres.com/real-estate-investing/articles/real-estate-vs-stocks-which-has-better-historical-returns/


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