“If you invest and don’t diversify, you’re literally throwing out money.” - Jeff Yass, Managing Director, Susquehanna International Group
- If you’re only diversified across publicly-traded assets (i.e. stocks and bonds), you could be leaving a lot of money on the table, and potentially be overexposing yourself to market risk.
- A portfolio allocated across asset classes can decrease exposure to systematic and unsystematic risks and increase your portfolio return.
- The Chief Investment Officer of the Yale Endowment advises individual investors to follow the “20% rule”, allocating 20% of their portfolio to real estate among five other asset classes.
Often recommended, diversification is a portfolio strategy that reduces risk by allocating investments into several different asset classes, especially ones uncorrelated to “traditional” assets like stocks and bonds. By diversifying your portfolio you insulate yourself from market dips, and are well-positioned to receive higher returns.
Why is Diversification Important?
Most of us invest to grow our net worth for a more stable financial future, but a lack of diversification can actually leave you open to greater risk and decrease the likelihood of meeting your long term financial goals. While relying on a traditional portfolio of only publicly-traded stocks and bonds may seem sufficient, the reality is you may be limiting your potential diversification and therefore leaving your portfolio open to greater risk.
Mitigating Risk: Systematic vs. Unsystematic
In investing, there are two types of risk: systematic and unsystematic risk. Systematic risk is risk that is inherent to the entire financial system. Some instances include interest rates, war, recession, and inflation. Diversification can help reduce the effects of some types of systematic risk. For example, diversification into real estate investing can help hedge against inflation. On the other hand, it is more difficult to diversify the risk of an economic recession.
Unsystematic risk is the risk that is associated with a particular company, industry, market, economy, country or region. These risks are specific to one element rather than widespread. Unsystematic risks can be lessened by investing across asset classes with lower correlation to one another.
For example, let’s say that you own stock in both American Airlines and Hertz. The market risks of the airline industry are not identical to those of the car rental industry, but they are highly correlated. Generally speaking as airline travel drops, whether as a result of inclement weather or high fuel prices, so does the volume of cars rented. This means that as a stockholder of both companies, the same singular outside force could negatively impact your returns on both investments. Alternatively, by investing in assets that have lower correlation you can offset the risk that the same series of events negatively impacts your entire portfolio.
Many investors believe it is wise to include alternative assets as part of a well-balanced portfolio, because they tend to have lower correlation with traditional stocks and bonds. Alternative assets, such as private market real estate, may be less likely to be negatively affected by the same issues that result in a decline in the stock value of airline and rental car companies. The inclusion of private market real estate in your portfolio can serve to mitigate potential losses from stocks as well as add additional return potential.
The differences between traditional and alternative investments help create a complete and complementary portfolio. By distributing your investments with consideration of systematic and unsystematic risk, you can improve the stability and performance of your portfolio.
Diversification for Better Returns
A diverse portfolio not only helps reduce risk, but also improves the likelihood of earning higher returns. By adding alternative assets to your portfolio, you can create a profitable asset mix that often outperforms a traditional portfolio. The below comparison demonstrates how a portfolio with increased private market diversification, particularly into real estate, has the potential for higher returns and lower volatility.
How to Build Your Own Diversified Portfolio
The Yale Endowment has consistently been a top-performing endowment over the past 30 years, earning a 12.9% 30-year market-leading return. The Yale Endowment’s success is often attributed to its use of the “20% Rule” allocating a minimum of 20% of its capital into real estate and other private market investing alternatives. Following this rule has been shown to both improve returns and lower portfolio volatility.
David Swensen, the Chief Investment Officer of the Yale Endowment advises individual investors who want to meet their investing goals to diversify into alternative assets in his book, Unconventional Success: A Fundamental Approach to Personal Investment. In particular, he recommends a diversified portfolio of:
- 30% Domestic Stocks
- 20% Real Estate
- 15% U.S. Treasury Bonds
- 15% U.S. Treasury Inflation-Protected Securities
- 15% Foreign Developed Market
- 5% Emerging Market
Institutions vs. Individuals
While many investors understand the importance of healthy diversification into alternative asset classes, institutional investors, such as pensions and endowments, allocate almost 30% percent of their portfolios to alternatives while individuals allocate an average of just 5%. The following graph compares the portion of portfolios allocated to alternative assets by institutional investors and individual investors in 2015.
Individuals stand to gain substantial benefits by diversifying their portfolio using uncorrelated, alternative assets. Simply put, alternatives offer a source of diversification that traditional assets cannot. Unfortunately, alternatives have historically been out of reach of individual investors. Some alternatives, such as venture capital funds and private equity funds are still out of reach of many ordinary investors. However, direct private market investing became available to everyone in the U.S. in 2012 through Fundrise, giving all investors the opportunity to put David Swensen’s suggested investing model into practice. With low fees and increased transparency, Fundrise offers individual investors the chance to strengthen their portfolio with direct diversification into real estate with a low minimum investment of just $500.