At Fundrise, diversification is at the root of many of our most important conversations. There’s a lot to say, a lot to praise, and a lot of different ways to say it — a diverse conversation about diversification.
However, for the sake of this article, we’ll be talking about diversification with a specific, practical meaning: to invest in holdings both inside and outside the standard markets. Namely, outside the stock market. That means a well-diversified portfolio will often hold both stocks and alternative investments.
Why? Holdings that belong to the same market tend to share similar behavior — they have high correlation to each other. When you add alternative investments on top of your stock holdings, you potentially lower your portfolio’s overall correlation.
And as many people know, lowering correlation also lowers risk. If, for example, the stock market takes a serious dip, a portfolio that also holds real estate will potentially suffer less than one that only holds stocks. Real estate is often less sensitive to many of the influences that can cause volatility in stocks.
But that idea of diversification is just the beginning.
In reality, it’s an ever-evolving topic and deserves regular exploration. It’s often not so cut-and-dried as “Add x, protect yourself from y.” And for sophisticated investors it’s not solely about insuring your portfolio by going beyond stocks — it has the potential to grow your portfolio too.
Many people might appear well-diversified but in practice are missing out on some of diversification’s key benefits. This article is designed to look at several truths about diversification that are likely unknown to many investors. Even seasoned ones.
After all, diversification isn’t intended to make your portfolio simpler — by definition, it adds more moving pieces, and that means both more complexity… and more potential for growth.
1) Diversification is most valuable over the long term — not just during a downturn.
As outlined above, one of the main narratives around diversification is that it proves its primary value when one market has a downturn. As common knowledge says, if you have a portfolio with holdings that correlate to a variety of markets, parts of your portfolio will be resilient when one segment dips.
While that’s all true — and crucial — it’s also an over-simplification. Diversification offers real value all the time, not just during a crisis. Investors who don’t understand the full scope of its value might unintentionally be leaving some money on the table.
Diversifying beyond stocks helps improve your overall investment performance on an ongoing timeframe, by balancing volatility on a daily basis, not just during a dip in market performance.
It’s possible to diversify your investments in a way that your portfolio’s overall behavior surpasses the performance you’d expect from a narrower range of investments. Again and again, portfolios have shown evidence of how long-term diversification boosts returns overall. (See the chart lower in this article to look at a specific example.)
But to realize that benefit, your diversified portfolio needs time and the opportunity to develop through multiple phases of the market, so the law of averages can do its work.
Investors who want to reap the full value of diversification have to preserve it for the long term — not just when they think there’s a downturn on the horizon. Diversification’s highest potential isn’t when it’s used in preparation or in reaction to market behavior, but as a core, constant tenet of smart investing.
2) Just because an investment seems unique doesn’t mean it’s your portfolio’s missing piece.
It’s easy to think that an investment looks like a fantastic vehicle for diversification because it seems significantly different from anything else in your portfolio.
But appearances can be deceiving, and some old assumptions about diversification have been debunked.
For example, it’s been shown repeatedly that the performance of international stock markets — despite thousands of miles of geographical separation — have a higher correlation to American markets than many investors might expect. And often this occurs during bear market periods — exactly when you’d think you’d want diversification the most.
Sometimes a more important factor in assessing an asset’s correlation isn’t the asset type itself but the structure of the market to which it belongs.
That’s why diversifying outside of stocks is so important — you push your investments beyond a public market — and why something like private market real estate can offer benefits that international stocks or even public real estate holdings cannot.
For example, in some situations, the behavior of a public REIT is more likely to correlate with the Dow Jones than with a private equity real estate fund — even though both the REIT and the private equity own the same asset type. Public markets are potentially more sensitive to the same influences automatically, even if their underlying assets seem quite different.
Don’t let an investment opportunity fool you because it appears exotic or rare. Be sure to dig deeper into your potential investment and ensure that however it’s structured will make it correlate to markets in the way you expect.
3) Diversification means expecting a range of performances. If it all looks the same, you might be doing it wrong.
It’s tempting to want to see every asset in your portfolio performing exactly the same way — and that way is “up and to the right.”
While that’s possible in moments when the market’s enjoying unfettered growth, diversification usually means that you should see a variety of performances across your portfolio throughout the lifetime of ownership. Remember, low correlation is what you’re looking for.
That doesn’t mean you should expect to make bad investments. Or that you should define good diversification as mixing bad investments with good ones.
But it does mean that if you’re diversifying outside of standard markets, you’re balancing risk, potential returns, asset types, market exposure, and more — and you’ll see some spectrum of performance, purely by virtue of statistics.
If you don’t see that to some extent, you’re probably not genuinely diversified.
4) Some products designed to provide diversification may do less than you expect.
Pre-packaged diversification vehicles are plentiful on today’s markets. Mutual funds, ETFs, and any number of other professionally managed funds provide automatic exposure to swaths of securities. These can appear to offer inherent diversification because spreading an investment over a variety of holdings automatically lowers correlation.
It’s easy to buy shares from a variety of these funds and feel like you’ve done your due diligence in ensuring satisfactory diversification. But do they really add something new to your portfolio? Are they actually giving you exposure to new markets — or just more exposure to the ones you already own?
What some investors don’t realize is that these funds that gather and bundle multitudes of securities are liable to overlap — sometimes more than just a little bit, and sometimes in a way that’s difficult to see without close examination.
In order to ensure this isn’t the case, you may need to delve into each of your indexes and compare their contents, security by security. Inspection like this can be time-consuming, but overlapping ownership is a real hazard for investors to recognize. The number of publicly-traded stocks in the US is shrinking (and has shrunk by 50% since 1997), and the number of options for public investors is increasingly limited too.
5) Diversification doesn’t eliminate risk. It harnesses it.
The easiest (and most common) way to understand diversification is that its purpose is to help avoid loss. You might think, “I won’t expose myself to investments with all the same weaknesses, and no single blow will ruin my whole portfolio.”
But that perspective misses the bigger picture. Diversification’s more exciting value comes not as a risk-aversion tool but as a profit-driving opportunity. When diversification is carefully balanced and calibrated, it can actually provide a mathematical edge to your assets’ performance.
How? When you diversify beyond the stock market, you’re potentially strengthening your portfolio with investments that have a mix of risks and potential returns. Doing that builds a strong foundation that can supports more aggressive, higher risk investments — and those can potentially deliver even better performance.
Check out this chart from another of Fundrise article, “How Traditional Diversification Leaves You Exposed and How to Fix It.” Note how Portfolio 3 benefits from both higher returns and lower volatility.
If you identify as a long-term investor, then diversification isn’t just a passive safety net — it’s an active strategy for producing higher returns, as the historical performance of funds like the Yale Endowment have demonstrated for years. Although it’s vital to remember that past performance doesn’t indicate future returns, the Yale Endowment has outpaced the market for decades by investing in private alternatives — 17% of its portfolio, in fact.
Finally, private market alternative assets like Fundrise’s real estate also present access to the possibility of market inefficiency… and that includes the possibility of actually beating the market. That’s a proposition virtually impossible to achieve if you’re only invested in stocks and public market assets.
How We Diversify
Though it’s called an “alternative asset,” real estate isn’t an investment that should be purchased instead of stocks — evidence has shown time and time again that traditional assets and real estate are most powerful when they complement each other.
In his book Unconventional Success, David Swensen, the Yale Endowment’s Chief Investment Officer, advises individual investors to follow the “20% rule”, allocating 20% of their portfolio to real estate among five other asset classes.
On top of that, every Fundrise plan includes a range and variety of holdings, completely unique and solely owned by our private fund, with a mix of risk and expected potential returns tailored toward specific investment goals.
These goals take into account whether an investor is more interested in, say, supplemental income or long-term growth — or if they’re just getting started as an investor — and gives them calculated levels of risk and diversification, weighed to help them achieve their personal financial targets.
When our investors become owners of Fundrise real estate, they’re not only securing their portfolios by diversifying into a new investment class. They’re often taking advantage of sophisticated and nuanced ideas like the ones outlined in this article, and deeper potential of common terms, like “diversification.” That’s what many of the world’s wealthiest investors have understood for decades, drawing them to investments like private market real estate.