Risk and return go hand in hand. Typically return expectations of investors increases as risk of the investment increases. Investors seek to reduce the risk by diversifying across industries, asset classes and investment horizons. Whilst diversification is a great way to reduce portfolio risk, often times macro events which cause drastic and severe corrections. The 2008 mortgage crisis was a classic example of that. While the crisis emanated in the housing market, the contagion spread to most public markets in the US and worldwide almost causing a collapse of the US financial system. Nonetheless, the power of diversification cannot be understated regardless of portfolio size and composition.
What makes a portfolio diversified:
Knowing the benefits of portfolio diversification, one may ask what makes a portfolio diversified. The key idea behind portfolio diversification lies in “correlation”. Correlated investment themes tend to perform similarly. By virtue of that, they would tend to do well under similar conditions and on the flip side do poorly under certain other conditions. One can achieve portfolio diversification by investing in assets that have low to a zero correlation among each other.
Swensen’s 20% rule and Real estate’s superior diversification potential:
The 20% rule created by David Swensen, the Chief investment officer at Yale endowment is a popular portfolio risk mitigation strategy and calls for allocation 20% of the portfolio towards alternative investments – one’s that have low correlation with traditional and publicly trades asset classes as as stocks and bonds. We argue that Real estate happens to one of the best choices to achieve near complete portfolio diversification. Some of the top reasons are:
1. Correlation advantage:
Real estate has a low correlation with stocks and bonds. Historically the correlation has been as low as 0 in the early 2000’s to as high as 0.8 during the mortgage crisis. The average correlation across the previous 4 decades has been around 0.3 or so. This is great news from a portfolio diversification standpoint.
2. Inflation advantage:
Real estate acts as a natural inflation hedge. Inflation hedge investments are investments that are expected to increase or at-least maintain their value over a period of time. The most typical example of that fact is the rising rental rates in most major sub-markets in the US. The sheer shortage of housing and the home affordability crisis has further caused an upward pressure on rents.
3. Illiquidity and market inefficiency:
Real estate is an illiquid investment. While that fact could be construed as a negative, there are studies conducted that demonstrate the fact that retail investors don’t make money over the long run in liquid markets. This if often attributed due to “market-timing” tendencies of retail investors and quite to the contrary Real estate’s relative illiquid nature helps more than hurts. Illiquidity often also leads to market inefficiencies which sophisticated market participants can exploit.
To your health and wealth!