When it comes to your portfolio, there’s one thing that’s certain: The market may be volatile, but a diversified portfolio is generally considered a smart strategy. Proper diversification offers the risk protection you need to sleep soundly at night, even in unpredictable times.
But what does a truly diverse portfolio look like? In today’s uncertain climate — with COVID-19 adding yet another layer of unexpected change — savvy investors know that choosing recession-proof investments, such as real estate, is more important than ever.
Here are 8 questions every investor needs to ask about diversification. Of course, we always recommend consulting a professional accountant or financial expert before making any major changes to your investment strategy.
1. What’s Your Risk Tolerance?
We started with this question because diversification is all about mitigating risk. Of course, some risk is inherent to investing.
But diversification can hedge against unsystematic risk, a.k.a. stock market volatility. Diversification spreads your investments across asset classes. If one asset class crashes — say, equities — your risk is reduced because you’ve also invested in other assets, such as bonds or real estate that may still be going strong.
Start by determining how much volatility you’re comfortable with. As a general rule, those with lower risk tolerance invest in less-volatile assets with a lower potential for return and lower risk of loss. Those with higher risk tolerance invest in more-volatile assets with a higher potential for return, but greater risk of loss.
2. What’s Your Risk-Adjusted ROI?
Of course, as an investor, you want to get the highest returns at the level of risk you’re comfortable with. Calculate the risk-adjusted return on investment to map out what this means.
This metric helps you determine the potential return you may receive at a certain level of risk. Your goal? To maximize return potential at whichever risk level you choose.
3. Are Your Assets Too Closely Related?
To reduce the most risk, choose assets with the least amount of correlation. That means investing in asset classes that don’t react the same way to market volatility.
For instance, if oil stock prices drop, correlated equities, or those that depend on the oil industry (such as airlines), may also fall. But assets with low correlation, like real estate, won’t be as affected.
4. How Many Asset Classes Does My Portfolio Contain?
A mix of stocks and bonds isn’t enough to achieve true diversification. When reviewing your portfolio, look for a wide range of asset classes, that also includes assets like real estate, commodities, and cash.
Different asset types have variable investment horizons and return structures. Reducing correlation reduces volatility, offering protection in uncertain times.
5. How Diverse are Your Assets Within an Asset Class?
Simply choosing different asset classes isn’t enough. An efficiently diversified portfolio will also have diversification within asset classes.
For example, if you have both stocks and bonds in your portfolio — but you only have a few of each — you’re not diversified.
Aim for a wide range of different assets within each asset class. Think index funds (which typically contain hundreds of stocks), and investment properties across different types of real estate, like single- to multi-family at different price points, in different areas.
6. Do You Have Market Diversity in Your Portfolio?
Another important consideration? Diversification across public and private markets.
Investments in the public market, while efficient, are also subject to high correlation and greater volatility.
In contrast, investments in private markets may be less efficient. But they’re also less homogenous and less correlated. Investing across markets can lower your exposure to volatility and, therefore, risk.
7. What About Inflation?
Here’s some sobering news: Even if your investments show a return, inflation can knock your earnings back down. Over time, the dollar tends to lose purchasing power.
Say you had a 4 percent annual return, but inflation rose by 3 percent. That means your wealth is growing slower than you think.
Fortunately, investing in hard assets, such as real estate, can hedge against inflation. Not only do hard assets’ value typically rise with inflation, but you can also continue bringing in revenue through rental fees.
8. Are You Being Strategic?
Just because you own a range of investments doesn’t necessarily mean you’re adequately diversified. A truly effective strategy will account for correlation, which may be hard to detect.
An analysis of your investment portfolio with a focus on eliminating correlation is the first step toward true diversification. We always suggest speaking with a professional who can help you make the best choices for your individual goals.
Investing in real estate is a great way to diversify your portfolio. Hard assets can reduce correlation and help protect you against market volatility. If you’d like to learn more about the real estate investment opportunities available to you, contact New Western today.