Diversification, or investing in a variety of different assets, has become a widely accepted method of managing risk and improving overall portfolio performance.
In 1952, Harry Markowitz, the “father of Modern Portfolio Theory,” performed an analysis of the stock market and identified two types of risk that are still applicable today:
- Systematic Risk: Broad market risk, such as geopolitical issues, interest rate changes, and widespread recession that cannot be mitigated with diversification.
- Unsystematic Risk: Risk specific to an individual investment, like the bankruptcy of an investment’s sponsor, for which diversification can help to minimize the effects.
Markowitz concluded that the optimal portfolio was one with increased diversification, which allowed an investor to maximize returns while mitigating unsystematic risks.
However, as today’s investor knows, it can be costly and difficult to create a truly diverse, efficient portfolio—and even more difficult to accurately assess and evaluate risk.
A New Opportunity for Diversification
For most people, diversification means owning an index fund or an array of ETFs.
However, this still leaves you susceptible to changes in the stock market.
The advent of real estate crowdfunding has created an entirely new opportunity for the average investor to increase the diversification of their portfolio.
The Fundrise eREITs give investors the ability to diversify into high-quality, high-yielding real estate, through an entirely new model with low minimums and fees. Most investors have never had the ability to allocate a portion of their portfolio directly to real estate (the way many institutional investors would). Rather, exposure to real estate would typically have to be achieved via publicly traded REITs, which are still correlated to the broader stock market.
The Need to Understand Risk in Real Estate
With increased accessibility to real estate investing, investors now need new methods for evaluating real estate risk.
Fundrise has created a proprietary rating system to help investors better understand and compare the relative risks in real estate across varying investments.
While every real estate investment is unique and carries its own individual risks, there are some consistent factors that can give an investor general guidelines with which to evaluate it.
For example, all other things being equal (location, leverage, sponsor, etc..) investing in the ground-up construction of a building is inherently riskier than investing in an existing building that is fully occupied.
The Fundrise rating system takes these factors into account and assigns a letter rating (A - E) accordingly. It’s important to recognize that the letter rating is NOT a measure of the quality of the investment. Rather, it’s simply a measure of relative risk. An “A” rated investment is believed by Fundrise to be less risky than a “D” rated investment.
The quality of an investment should be determined by whether the potential return is appropriate given the relative level of risk (and if that then fits within an individual investor’s investment strategy). While a “D” rated investment is not worse than an “A”, it should offer a greater potential return to compensate for the risk.
In addition to the rating system, Fundrise provides a risk-adjusted return comparison for each investment, showing how that investment’s projected return compares to other investments with a similar risk rating.
The Fundrise risk-adjusted return is based on Harry Markowitz’s concept of the “Efficient Frontier”—an investor should aim to build a portfolio that offers the highest expected return for a given level of risk.
Portfolios that fall below the efficient frontier are sub-optimal because they do not provide enough return for the risk.
The Fundrise rating system and risk-adjusted return graph are just two of the many ways we seek to add much-needed transparency to the new model of online crowdfunded real estate investing.