Why Is Portfolio Diversification Important?

Investing can be one of the best ways to build wealth and reach long-term financial goals. Though there’s no right answer to what you should invest in, there is one principle that many people use to guide their investing decisions: diversification.

Diversification is spreading your risk across different types of investments to increase the odds of investment success and hedge against potential poor-performing or under-performing investments. It may also increase your overall return without requiring an investor to sacrifice something in exchange, which is why some investors and economists may call it a “free lunch.” Here is why it is important and how you can begin diversifying your portfolio today.

What Is Diversification In Investing?

In practical terms, diversification is holding investments which react differently to the same market or economic event. For example, when an economy is growing, stocks tend to outperform bonds. When the economy slows, however, bonds tend to do better than stocks. This same idea can be applied to commercial real estate investments.

Each type of asset performs differently. Historically, stocks have offered the potential for the highest return over time with a tendency to fluctuate wildly over shorter periods, but in recent years, they have been outperformed by other asset classes, especially real estate. Bonds can offer steadier returns than stocks with a fixed payout but can vary as interest rates rise and fall and have also suffered from lower returns when compared to other types. Meanwhile, funds tend to be diversified because they usually hold many investments, but a specific fund might hold only one kind. Thus, a fund can be broadly or narrowly diversified, depending on how it is managed.

CDs and savings accounts will not fluctuate in value but will grow steadily based on interest rates and other contractual terms. Despite this steady growth, the rates of return on CDs and savings accounts are marginal compared to other forms of investment.

Real estate, including commercial real estate, can appreciate over time and offer the potential for income, but may be expensive to maintain. Still, many investors invest in real estate because it may hedge against inflation, and in recent years, it has been performing well despite economic conditions. For example, multi-family continues to do well in the current market as demand for housing increases.

There are two ways to diversify your portfolio: across and within asset classes. When you diversify across asset classes, this means you have multiple types of investments, such as stocks and real estate. When you diversify within an asset class, your investments are spread across many investments within a certain type. In commercial real estate, this could look like buying or investing in multiple types of buildings.

The Benefits Of Diversification

Compounding returns are key to growing a portfolio over time and avoiding losses. While there is no guarantee you’ll avoid all potential losses, a diversified set of investments may save you from the worst effects of a poorly performing asset.

You also do not want to put, as the saying goes, all your eggs in one basket. Putting money in one company or a handful of companies can be very risky. While individual investments can suffer declines, it is less likely that two or three investments within completely different asset types, and with different sources of risk and return, will experience declines simultaneously. Different asset classes and even different investments within the same class behave differently depending on market conditions. For example, even if your stocks decline, having some investments in gold may keep your portfolio from falling as far in value as it might without another asset to hedge the effects.

Another example showing the importance of diversification is the financial crisis of 2008. Anyone exclusively invested in financial stocks in late 2007 and 2008 would have experienced significant losses due to the subprime mortgage crisis. The assets that were least affected were private equity, venture capital funds and REITs, among others, and those investors with these in their portfolio likely saw fewer losses than those who solely invested in stocks. An earlier example would include those investors who choose to fill their portfolio with tech stocks in 2000, only to have the dot-com bubble burst and technology shares rapidly fall out of favor. Like the investors in 2008, the lack of diversification resulted in some investors losing a large portion of their capital.

Diversification can also help combine assets of different risk levels into a single portfolio. Stocks and bonds have produced higher returns in the past, but real estate investments have recently outperformed these traditional varieties and can hedge some of your portfolio’s risks in years when the stock market is down.

What this means for investors is that diversification can stabilize your portfolio and create a balance between risks and rewards. Depending on your level of diversification and the portfolio size, it’s possible that no single investment can hurt you, and diversification smooths your returns. You may also gain more opportunities for returns. Though diversification doesn’t completely eliminate risk, it is still a good principle to follow.

How To Diversify Your Portfolio

Do not mistake diversification with owning a large number of assets. There is no magic formula to tell you exactly how many you should own or which you should invest in. Instead, the trick to diversifying is owning investments that play different roles in the portfolio. This means including investments whose returns aren’t correlated with one another. If the market ever affects a part of them, it won’t affect the whole thing or it has an opposite effect on another part of your portfolio.

You may also include assets other than stocks in your portfolio. This is where commercial real estate can help. Depending on the property type and real estate market, owning a physical asset may have stabler returns than traditional stocks and bonds. Investing in commercial real estate also comes with its own benefits, including the potential for dependable returns and steady income through rent. Commercial real estate may also act as a hedge against inflation. 

Another common mistake investors make is investing in multiple funds without realizing these funds tend to overlap in the types of assets they contain. An investor might invest in an S&P 500 index fund and a total stock market index fund, thinking they’re gaining a variety. In reality, these two funds may overlap since about 75% of the total U.S. equities market is made up of stocks that are already part of the S&P 500. This investor has now invested in the same companies twice.

The appropriate level of diversification is not set in stone and is dependent on your financial goals, time horizon, and risk tolerance. As these factors change over time, so should your portfolio. The assets should reflect your changing financial goals and other factors to best serve you and your goals.

You may check to see if your portfolio is diversified by analyzing your current performance. Your assets shouldn’t all be moving in the same direction at the same time. If they are, it likely indicates your collection of investments is not diversified enough and you may need to look into investing in other types.

Invest With Avistone

Diversification may help an investor manage risk and reduce the effect an asset’s price movements has on a portfolio. Even if risk is not eliminated completely, the risk is reduced and there is a potential for steady returns from another asset. The goal is to find equilibrium between risk and returns to achieve your financial goals.

If you’re looking to diversify your portfolio via commercial real estate, consider investing with Avistone. We are a rapidly growing commercial real estate investment firm, focusing on the acquisition and operation of multi-tenant flex/industrial properties, as well as the acquisition and asset management of hotel properties nationwide.

We offer accredited investors the opportunity to purchase equity shares with the potential to receive monthly cash distributions and capital appreciation upon sale. Since our founding, we have acquired 26 industrial and hotel properties with over 4 million square feet of space in California, Georgia, Texas, Florida, and Ohio.

Contact us today to learn more about our current offerings.