To Diversify or Not to Diversify

Where do you stand in the debate amongst investors as to diversify or not to diversify?

When you boil it down, it really comes down to your risk tolerance and your overall knowledge about investing.

As you all know, investing is a very personal endeavor that rides on each investor’s personal goals, so it’s important to note that there isn’t a right or a wrong side in this debate.

But to take a side, you need to hear the logic of both sides.

So in this blog post, we will delve into the arguments in favor of diversification, the arguments against diversification, and discuss the times when diversification is absolutely crucial.

Let’s get started!

The Traditional Path of Diversification

Traditionally, investors have been advised not to put all their eggs in one basket. You’ve probably heard this before, right?

The principle of diversification involves spreading investments across various asset classes to mitigate risk and achieve a balanced portfolio.

This approach typically includes investments in the stock market, bonds, international stocks, commodities, and real estate. So you’re dipping your toes into a little bit of everything with the hope that if one asset class goes under, the others will keep your portfolio afloat.

Importance of Diversification in the Traditional Sense

The merits of diversification have been demonstrated during historical periods when diversified portfolios outperformed non-diversified ones. 

For example, during “the lost decade” from 2000 to 2009, the S&P 500 index remained flat. However, an individual who diversified their portfolio across various index funds, foreign stocks, bonds, emerging markets, and real estate saw substantial annualized returns of around 6.7% during a period that saw poor returns for so many investors.

You can see how much of an impact diversification had on that portfolio.

Now, Ray Dalio also talks about his strategy of investing in 15 uncorrelated investments across stocks, bonds, real estate, gold, commodities, etc… with the goal of reducing your risk by 80% while increasing returns by 5%. 

And the logic here is to give your portfolio asymmetric risk reward. So you’re reducing risk while increasing reward. That’s the goal of diversifying!

The Argument for Not Diversifying

Diversification sounds pretty good, right? Relatively strong returns, limited risk. So why would anybody want to not diversify?

Well, let’s defer to Warren Buffet on this one.

He famously stated that “diversification is protection against ignorance and is not necessary for those who thoroughly understand their investments.” 

This argument emphasizes the potential of sticking to one or a couple asset classes when investors possess a deep understanding of the market and the right strategies. 

And I have to say that in the 10 or so years since I started investing, I’ve moved into this camp of thought.

As I’ve learned more and more about real estate investment strategies and how to get the most out of things such as tax advantages and leveraging, I’ve started to take my eggs out of other baskets, such as the stock market- and put them back into my real estate basket.

The Benefits of Real Estate Investments

Let’s talk a bit more about real estate.

Compared to traditional stock market investments, real estate offers unique advantages that can lead to superior returns. 

One of these advantages, like I mentioned before, is leveraging real estate through mortgages, which can amplify returns through capital appreciation.

Additionally, cash flow from rental properties and tax savings further boost returns, making real estate an attractive investment option.

If you look at the years 2020 and 2021, a lot of people during these times were doing day trading and options trading, and they were looking at returns of 20-30%.

That sounds terrific, but if they’re in a high tax bracket, their returns could be cut by half, bringing their actual returns to 10-15%.

Compare that to a property that you buy for $200,000 with $50,000 down during the same period. It would’ve experienced a 20% increase in value, which is essentially $40,000 more in your pocket. 

You’re looking at an 80% ROI!

And if you were able to tap into advanced tax savings, then that’s potentially another $50,000 of income sheltered from taxes.

That ROI is now up actually somewhere between 80-150%, depending on how the tax savings worked out.

So you can see the power of keeping your money in real estate rather than diversifying it to other places such as the stock market, bonds, or debt funds. 

But it’s important to come back to what Warren Buffet said. 

Because without a deep understanding of the financial tools at an investor’s disposal within one asset class, placing all of your eggs in one basket could be a risky play that doesn’t lead to the returns we’ve talked about here.

But with the right knowledge and an adversity for ignorance, investing primarily in real estate can be a tremendous move in the direction of financial freedom.

When to Consider Diversification Within Real Estate

So let’s say that you’re Warren Buffet and you’ve decided to invest primarily in real estate.

There’s still some inherent risk, and you’re going to want to reduce that as much as possible.

So how do you do that?

Well, you know that you want to stick to real estate, so you’re not going to invest in other asset classes. But you do have the option of diversifying within the same asset class.

For example, investors involved in high-risk opportunities or ground-up developments during uncertain economic cycles may consider diversifying into lower-risk assets with stable cash flow and tax efficiency.

Similarly, investors heavily engaged in short-term rentals should evaluate adding long-term rentals to their portfolio for better risk management. 

Since short-term rentals are more susceptible to macroeconomic trends, balancing the portfolio with long-term rental properties can provide stability.

Diversification across markets also plays a crucial role, especially in regions prone to natural disasters. 

Investors should avoid concentrating all their assets in a single area to safeguard against potential risks associated with local market fluctuations.

Time As a Diversification Tool

Another opportunity for diversification in real estate is by spreading your investments out through time.

Attempting to time the real estate market is a challenging endeavor, and even seasoned investors often struggle to do so accurately. 

So instead of trying to predict market movements, investors can capitalize on opportunities during market cycles. 

Recessions and recovery phases, often feared by many, can present the highest opportunities for strategic real estate investments. 

By adhering to well-defined criteria and planning for worst-case scenarios, investors can navigate market cycles more effectively.

And by spreading out investments through time, they can count on asymmetric risk-reward diversification, where even if some investments under perform, the others will pick up the slack.

In the debate of to diversify or not to diversify, all investors must carefully consider their investment goals, risk tolerance, and understanding of the market. 

Because after all, there are two camps in the diversification debate for a reason.

Diversification has undeniable merits in traditional investing and it has served many people extremely well.

On the other hand, not diversifying and focusing on something like real estate offers unique opportunities for those who can strategically leverage their knowledge. 

But regardless of where you stand in this debate, it’s essential to remain open to learning and adapting to market conditions in the ever-changing landscape of investments.

By striking the right balance between diversification and specialization, investors can pave their way to long-term financial success.

So whether you choose to diversify across asset classes or concentrate on mastering the real estate market, the key lies in making informed decisions that align with your investment goals.

Happy investing!

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