As an investor, you’ve likely heard diversification in your portfolio is crucial. That said, you may not know how it works to your advantage or how to achieve it.
This article will deepen your understanding of diversification, the various options at hand, and how to access them. Then, you can take a more active role in strengthening your portfolio with potentially less overall risk.
How Safe is “Safe”?
Any investment, no matter the type, is a simple risk-versus-reward equation. The higher the risk, the higher the potential return. Lower the risk, and you lower your return, but ostensibly achieve more security.
Yet, is it truly more secure to “play it safe” by engaging in only traditional or conservative investments? The answer lies in statistics.
When we talk about the volatility of a stock, for example, we’re talking about the level of risk. And that risk is quantified via a statistical measurement called standard deviation. This formula calculates the variability of return for an investment over time. The lower the standard deviation in the performance of that stock, the lower the risk.
Given this, simple logic dictates that when you are evaluating an addition to your investment mix, you should look at investments that individually show a low standard deviation. Right?
Not so fast. Welcome to the concept of correlated vs. non-correlated assets.
Riding the Rollercoaster
Now, let’s look at the total mix of investment types in your portfolio. In scenario one, let’s say all of your assets are stocks or bonds. Further, let’s say each of those have a similarly low standard deviation.
Only one problem: What happens when there’s a broad shift in the market due to a macroeconomic impact? Those stocks and bonds that felt like a safe bet all take the same plunge, leaving the overall value of your portfolio in the doghouse. This is because your assets are what we would call “correlated,” meaning that their value moves in tandem.
In other words, when the market is up, you’re riding high. But you’re in for a rollercoaster ride every time there’s motion in the market.
The Solution? Balance.
Now for scenario two. Part of your portfolio includes stocks and bonds, which we now know are all somewhat correlated. In this case, though, you’ve mixed things up by adding a different class of asset; in this example, a commercial real estate investment.
The market effects all assets to some extent. That said, while the value of a stock is highly reactive, a commercial real estate investment generally stretches over time, during which the property may still perform during macro fluctuations: leases are already in place, renters are still paying rent, etc.
Research confirms this theory, showing that commercial real estate assets have a low or negative correlation to stocks and bonds. Thus, adding these assets to your mix rights the boat, creating balance–or a lower standard deviation–in your overall portfolio.
Making it Happen with Real Estate
To take part in a commercial real estate offering, you need to be an accredited investor. But you also need access to the actual deals, which has historically required “knowing somebody” or seeking a dedicated engagement in the industry.
CrowdStreet’s marketplace offers access to a variety of deals for investors who haven’t had the opportunity to diversify into real estate. Even better, we give you direct access to project sponsors. You can ask questions, dig deep and develop a realistic picture of risk vs. reward related to a specific offering to determine its potential benefit to your portfolio.
The Takeaway
To be clear, a mix of correlated and non-correlated investments doesn’t impact the return on the assets themselves. However, the goal of investing is to get the maximum amount of return per unit of risk. Hedge your bets with a mix of non-correlated assets to achieve an optimal portfolio.