Diversification: A Comprehensive Guide
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Introduction: Why is Asset Diversification So Important?
“Don’t put too many eggs in one basket.” The adage has held true for centuries. As you may already know, diversification—the use of a larger range of inputs in a given process—can reduce risk and lead to a larger range of favorable outcomes. Take, for instance, these classic examples:
The same principle carries over to the investing process: in an investor’s portfolio, diversification can limit the possibility of any one asset’s performance having an outsized negative impact on overall returns. It’s a credo that many investors intuitively understand, though it’s mostly discussed within a narrow context: publicly traded stocks.
As seasoned investors know, however, there’s a world beyond stocks and bonds with broader horizons for diversification potential. Alternative asset classes provide a powerful means of diversifying, and platforms like EquityMultiple are designed to aid accredited investors in accessing these once hard-to-find opportunities.
In this article, we will discuss several foundational concepts related to portfolio diversification before going in depth on how individual investors can gain greater exposure to private-market alternatives such as real estate.
Volatility and Risk
When discussing diversification, volatility and risk are two indispensable concepts.?
Put simply, volatility represents the probability of adverse results for an asset (or a portfolio as a whole) at any point in time. It is typically measured by its standard deviation—the degree to which an asset’s value or returns stray from the average for any given period of time. Risk, on the other hand, generally refers to the possibility that an investment will gain or lose value.?
These terms are similar, and in practice they are often used interchangeably. That said, there is a key difference: volatility is a measure of price, whereas risk is a measure of value.
Risk is further defined in two different ways—
Alternative assets such as real estate, however, have historically exhibited a lower degree of systematic risk, responding less severely to (or, in some cases, contrary to) macroeconomic, geopolitical, and sectoral shifts. As a result, asset managers, institutional investors, and financial advisors have increasingly sought to allocate alternative assets in order to mitigate exposure to systematic risk.
Alpha and Beta
The terms “alpha” and “beta” are frequently thrown around in investing, and they are helpful in understanding the difference between alternative and traditional assets.
Beta is a quantitative measure of how closely an asset correlates with the overall market; to sum up, it is a measure of volatility. A beta value of 1.0 means that an asset is perfectly correlated with the market. Therefore, a beta value below 1 means that an asset is less volatile than the market as a whole, and a beta value of greater than 1 indicates that an asset is more volatile than the market as a whole. Beta is commonly used to assess the performance of traditional publicly traded assets, such as stocks and bonds.
Alpha, by contrast, does not measure volatility. Instead, it measures the return on an asset above what would be expected based on its level of risk. In the case of private-market alternative assets, alpha is more useful than beta, because these assets’ returns have little to do with the dynamics of public markets. Instead, expert assessment of opportunity and quality management are the main determinants of returns; even within similar sectors, strategies, and macro conditions, different managers can yield vastly different results.
In the case of a private real estate asset, for example, skilled management may entail moving into a new market or submarket that exhibits promising demographic trends and sound fundamentals, and achieving a favorable basis going in, before eventually adding value through renovations and professional property management that generate an improved net operating income (NOI)—and thus returns.
Experienced investors will seek exposure to both alpha and beta in their portfolios. Beta can provide exposure to broad-based economic health, and instruments such as index funds—which buy public equities across sectors or the entire economy—can provide predictable appreciation over the long term. Alpha investments can perform well during times when public markets are yielding poor aggregate returns, exhibiting high volatility, or both. Incorporating both investment categories into a portfolio can generally offer more diverse opportunities and improved protection against economic downturns.
Modern Portfolio Theory: A Quantitative Framework for Diversification
The modern portfolio theory (MPT), originally devised by the economist Harry Markowitz in 1952, has historically been a useful theoretical framework for evaluating and optimizing asset allocation — and it holds up in the 21st century.
Writing in the Journal of Finance, Markowitz provided individual investors with a formula for structuring an investment portfolio to maximize portfolio returns for a given level of risk (or, equivalently, to minimize risk for a given target portfolio return.) He would later win a Nobel Prize for his work on MPT. For our purposes, Markowitz’s key takeaway was that investors can achieve more favorable risk-adjusted returns by reducing the level of cross-asset correlation within their portfolios. A straightforward example: investing in 2 assets and incurring a loss on one is an (up to) 50% impact on the overall portfolio, whereas investing in 100 assets and incurring a loss on one is an (up to) 1% impact on the overall portfolio.
Practitioners of the MPT use an analytic process called mean variance optimization to calculate cross-asset correlation and optimize toward asset allocations that minimize portfolio-level risk (i.e. volatility) for any given level of expected aggregate return. They also use a graphical concept called the efficient frontier to assess portfolio construction. The efficient frontier plots the expected return on the Y axis against volatility—a proxy for risk—on the X axis. An investor can shift their efficient frontier upward with improved diversification and reduced cross-asset correlation.
Haven’t taken a math class in a while? Don’t worry. The basic premise serves as a valuable guidepost: in building a portfolio, diversification across uncorrelated assets is the key to minimizing risk.
The Evolution of Modern Portfolio Theory
In the 21st century, index funds and public REITs are burgeoning in popularity, and public markets have exhibited a greater tendency toward volatility.
When Harry Markowitz debuted the MPT in the 1950s, the economic landscape was remarkably different from what it is today. Index funds, ETFs, and REITs had not yet been invented, public markets offered a broader set of low-correlation assets, and individual investors had more opportunity to reduce cross-asset correlation within a portfolio of traditional assets like stocks and bonds.
Individual investors looking to align their portfolio strategy with the MPT must adopt a more creative approach by looking into private-market alternatives. Private assets, such as infrastructure investments, private equity, collateralized debt, and real estate, have historically exhibited low correlation with stocks and bonds—the “meat and potatoes” of a typical investor’s portfolio—and thus provide ample opportunity for minimizing cross-asset correlation.
A Brief History of Private-Market Alternatives
For decades, large institutional investors—pensions and endowments, mainly—have provided a practical, multi-decade example of how alternative investments can be utilized within a portfolio.
Yale University’s endowment, for example, increased its holdings of alternative assets from 12% in 1986 to a high of 80% in the 2010s. Similarly, alternative assets constituted over 75% of Harvard University’s endowment in 2023.
Historically, real estate has been a particular focus for these institutional investors, with a substantial portion of their portfolios going to private real estate — often on the order of 15–25% — across market cycles.
These private-market alternative assets have historically been opaque and inaccessible for individual investors; in past decades, only large institutions or ultra-wealthy individuals were well-connected enough to diversify in this manner. EquityMultiple connects accredited individuals with thoroughly vetted and professionally managed commercial real estate assets, ideal for minimizing cross-asset correlation in a portfolio already allocated to stocks and bonds.
Real Estate as a Target Asset Class
Real estate has come into focus in the past decade as a target asset class for individual investors seeking improved diversification.
Real estate investing is often referred to as a “structural” allocation of invested capital (as opposed to a “cyclical” one)—it relates to the functioning of not just the economy, but also urban society at large.
While the values of public equities may fluctuate with the whims of investor perception and shift dramatically in response to major geopolitical events, the demand for real estate assets tends to reflect slower-moving, more tangible demographic trends and macroeconomic factors.
Real estate values do tend to move cyclically, but not as precipitously as those of public equities; broadly, the real estate asset class has exhibited less historical volatility than the stock market. The same macroeconomic factors that shape stock market fluctuations also impact real estate values, to be sure, and many property types—or “subasset classes” within the real estate asset class—tend to be adversely impacted by economic downturns. However, certain property types such as self-storage exhibit consistent durability throughout economic cycles.?
This can be framed in another way: the performance of the real estate asset class depends on macroeconomic factors, but also moves in lockstep with primary economic indicators like GDP (and this is particularly true of such subasset classes as self-storage.) Therefore, real estate has historically exhibited low correlation with both the stock market and bond markets. It is also worth mentioning that valuations of real estate are not set continuously throughout the trading day, but rather via periodic appraisals, which inherently lowers volatility and helps drive the lower correlation with public markets.
Looking more closely at the traditional 60/40 portfolio, each side taken separately—debt (bonds) and equity (stocks)—can be diversified using real estate. Real estate debt investments, such as senior and bridge loan investments, can act as a diversifying element within the bond allocation. By the same token, private real estate equity investments like value-add or opportunistic limited partnership stakes can complement and diversify a typical stock allocation.
Tying back into our discussion of Modern Portfolio Theory, investors can potentially shift their efficient frontier upward by diversifying into real estate and partially allocating away from public equities.
Moving Beyond the 60/40 Portfolio to Capture Inflation
2024 has been defined by a turbulent economic environment, with the Federal Reserve raising interest rates to combat high inflation. As a result, diversification that solely relies on stocks and bonds has become less effective. For most of the last century, bonds’ low correlation with stocks protected portfolios from stock market volatility; due to higher borrowing costs in recent times, however, the correlations between stocks and bonds have increased. Therefore, alternative investments as a broader asset class have increasingly appealed to investors due to their tendency to offset high inflation and generally lack correlation with publicly traded stocks and bonds. Moreover, certain real estate assets such as multifamily can effectively “capture inflation”—since real estate is only appraised around once a year and traded infrequently, it has better long-term stability and more diversification potential in general.
Recent studies by the CAIA Association (below) emphasize the smaller maximum drawdowns experienced by portfolios consisting solely of alternative investments. A portfolio with equal allocations to private equity, private debt, hedge funds, and real assets experienced maximum drawdowns at least 20% lower than those of a traditional 60/40 portfolio (60% stocks, 40% bonds) over the trailing 10- and 15-year periods as of the fourth quarter of 2020. Furthermore, this all-alternatives portfolio exhibited superior risk-adjusted returns, with a Sharpe ratio of 1.38 over 10 years and 0.87 over 15 years, compared to 0.66 and 0.43, respectively, for the 60/40 portfolio over the same periods.
According to recent research by JPMorgan Asset Management (below), traditional portfolio allocations like the 60/40 (60% stocks, 40% bonds), 40/60, and 80/20 underperformed or had inferior risk-adjusted returns compared to portfolios that reduced their stock or bond allocations and included alternative investments. JPMorgan’s analysis suggests that adding a 30% allocation to alternative investments improved the performance of these portfolios. For instance, the 60/40 portfolio, when reallocated to 40/30/30 (stocks/bonds/alts), saw its Sharpe ratio increase from 0.55 to 0.75 over the period from 1989 to the first quarter of 2023. Similar improvements in Sharpe ratios were observed for the adjusted 40/60 and 80/20 portfolios.
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Research by KKR (below) examines how incorporating alternative investments can potentially enhance a portfolio's performance, particularly in different inflationary environments. By analyzing four distinct portfolio compositions over a period spanning more than 20 years, the study found that portfolios with allocations to alternative investments generated higher Sharpe ratios compared to traditional 60/40 portfolios (60% stocks, 40% bonds). This superior risk-adjusted performance was observed during both high and low inflationary periods, despite the alternative investment strategies being less liquid.
Types of Real Estate Assets
Single-Family Homes
This form of real estate investing is popular among numerous individual investors, particularly in a strong housing market, and it’s not hard to see why. Investors with the time and wherewithal to make cost-efficient upgrades to purchased single-family homes can turn a healthy profit on their investments. Thus, these investments exemplify the idea of “real estate investing” for many laypeople, and may indeed be satisfying and lucrative for those interested in a hands-on approach. There are a couple of major drawbacks, however:
REITs
Much like index funds, REITs (real estate investment trusts) were developed in the 1960s to afford smaller investors an opportunity to diversify within an asset class using a single, relatively small capital commitment. REITs aggregate income-producing real estate assets and pay out regular distributions to shareholders.
Although REITs do offer individual investors a solid entry point to the real estate asset class, publicly traded REITs do not offer the fundamental benefits of alternative assets for the simple reason that they are traded. As a result, they reflect broader market sentiments and tend to correlate more closely with the stock market than private-market, discrete real estate assets.
Commercial Real Estate Syndication
The concept of a syndicated real estate investment has been around since the beginning of recorded financial history. It is a simple, intuitive instrument that can benefit all parties: a lead investor assumes the majority of the risk and material work of a real estate investment, and some portion of the interest in the investment is passed along to passive investors. The lead investor is then typically entitled to an outsized share of profits if the investment goes well in exchange for assuming a greater degree of risk and liability. This also incentivizes the lead investor to act diligently and maximize returns for all parties involved.
In the U.S. today, the lead investor is typically referred to as the “sponsor” and as the GP (“General Partner”) in legal documents, while the passive investors to whom the investment is syndicated are referred to as LPs (“limited partners”). Passive investors typically enter into syndications as part owners of a discrete legal entity, typically an LLC.
While some investors have been able to tap into commercial real estate syndications throughout the past several decades, legal barriers and opacity made frequent participation all but impossible for most investors until the JOBS Act of 2012.
Real Estate Crowdfunding
From a regulatory standpoint, the JOBS Act enabled “general solicitation” of private real estate investments to individual investors. Simultaneously, the emergence of online platform solutions facilitated the large-scale marketing of syndications. This new paradigm, in which web applications connect individuals with private real estate investment opportunities at relatively low minimum investments, has become known as “real estate crowdfunding” or “real estate crowd investing.”
Since the real estate crowdfunding industry launched in 2014, dozens of firms have emerged, with a small cohort of platforms rising to prominence within the broader landscape of tech-enabled investing solutions for individuals.
In the past decade, the real estate crowdfunding industry has undergone rapid growth, to the point where investing platforms have been able to clarify business models and fall into several distinct categories with regard to the types of investments offered. In the next section of this article, we’ll discuss different real estate crowdfunding platform models, which have allowed individual investors to access private real estate investments at historically low minimums. These platforms have led to an abundance of new opportunities for diversification, both for whole portfolios and within the real estate asset class.
A Spectrum of Options
There are now a myriad of ways for individual investors to tap into the real estate space. For an investor with a sizable portfolio, there may be room for every form of real estate investment, particularly if real estate as an asset class is compelling on a personal level.
Single-family home investing can provide the satisfaction of a truly tangible investment; publicly traded REITs can offer exposure to the strength of the broader real estate market; and private real estate—accessed through real estate crowdfunding platforms like EquityMultiple—can offer the opportunity to decorrelate from the performance of traditional assets and diversify a portfolio even more.
EquityMultiple believes that individual investors benefit the most by spreading their real estate allocation across different assets that span various markets, property types, operators, projected terms (holding periods), strategies, and risk/return profiles. This approach reflects the fundamental case for diversification: the greatest rewards come from not putting all of your eggs in one basket. Moreover, just as diversification across asset classes mitigates portfolio risk, diversifying within the real estate asset class reduces the correlation between individual investments even further. Our three pillars—Keep, Earn, and Grow—help investors access investments that align with their goals (income, upside potential, or a mix of both).
Ultimately, diversifying your real estate investments across several parameters can lead to less volatility and may eventually reduce the risk exposure of your entire portfolio.
The Capital Stack & Diversification of Position
Instruments in real estate financing can be visualized as a vertical sliding scale, going from low-risk at the bottom to high-risk at the top.
Senior debt and other debt-like instruments offer the most security—like a mortgage in residential lending, commercial loans are typically secured by property. Conversely, common equity investments offer little to no security. These opposing positions on the “capital stack” offer the inverse with respect to return potential; investors are compensated for increased risk with respectively greater returns. While debt investments offer a fixed rate of return and the greatest amount of security, common equity investments offer uncapped upside; there is no limit to the potential return an investor can earn if an investment performs well.
Between senior debt and common equity in the capital stack are a variety of instruments that offer intermediate return potential and a degree of risk lying between those of senior debt and common equity investments. These are often referred to as “bridge financing” instruments, and their most common forms are mezzanine debt and preferred equity. Essentially, both structures offer some degree of recourse in the event of a sponsor default, but are subordinate to the senior loan. Investors are entitled to a flat rate of return that typically falls between the high single digits and high teens, depending on the market for capital. In the case of a preferred equity investment, investors may also be entitled to a fixed portion of the upside should the investment perform well.
Position in the capital stack is a key determinant of the risk/return profile of a real estate investment. Some investors may prefer to select a position in the capital stack that aligns with their overall investing strategy; for example, a risk-averse investor nearing retirement may opt for only senior debt investments in order to preserve capital. Many investors, though, will be best served by diversification across the capital stack. This holds true for two reasons:
A Note on the Future: While macroeconomic forecasts—and the consequences for the stock market—are a matter of constant debate, the continued urbanization of the U.S. is undeniable. Both urbanization (the proportion of Americans living in urban areas) and urban density have reliably gone up over the past 40 years, with both trends expected to continue in the coming decades. As such, many institutional investors are allocating greater portfolio share to real estate, where broad demographic trends support growth of the asset class independent of the business cycle.
Types of Diversification
Diversifying Across Property Types
Commercial real estate has traditionally been divided into four core property types (or “subasset classes”): multifamily, office, industrial, and retail. Recently, various niche property types—car washes, self storage complexes, senior living facilities, and others—have received attention from institutional investors. While these property types all fall under the umbrella of real estate, they may respond quite differently to macroeconomic factors and perform differently throughout market cycles.
For example, retail properties are typically harmed in short order by a drop in consumer confidence, but multifamily or self-storage facilities may remain largely unaffected—or even experience positive demand as would-be homeowners downsize during an economic downturn.
Diversifying across property types may help to mitigate the negative impact of a macroeconomic shock and insulate your real estate portfolio—and your portfolio as a whole—from market swings.
Diversifying Across Markets
Markets—the cities, neighborhoods, and metro areas across the U.S. where real estate capital flows—also react differently across economic cycles. Each market exhibits unique demand drivers and demographic trends. For instance, a geopolitical event impacting foreign trade may adversely affect real estate values in a trade-reliant market like Seattle, whereas Houston's economy, largely driven by the biomedical and energy sectors, may emerge relatively unscathed.
In general, larger, established primary markets like Chicago or New York display a more diversified set of demand drivers, making commercial real estate investments in those markets relatively safer. However, this economic vibrancy also attracts higher competition among investors, compressing return potential. Emerging secondary and tertiary markets typically present more growth opportunities and chances to find undervalued assets, but they also have a narrower set of demand drivers and therefore a generally higher degree of risk.
Similarly to property types, diversifying across markets can insulate your real estate portfolio from volatility and help balance risk and upside potential.
Diversifying Across Strategies & Business Plans
When investing in a single-family home as a rental property, the investment strategy typically revolves around identifying an an undervalued property in an emerging neighborhood where the potential rental income can surpass expenses such as insurance premiums, mortgage payments, utility bills, and maintenance costs. Unless you have expertise in construction and renovation, your investment options will likely be limited to existing homes on the market.
Commercial real estate investing strategies share a common foundation: sponsors seek properties with a favorable acquisition price, offering the potential for robust net operating income based on a thorough analysis of rental comparables, or the opportunity to achieve significant value appreciation based on sales comparables in the area. However, institutional investors may employ various strategies to drive growth in occupancy rates, increase average rents, or add value and reposition the property for a favorable exit and robust realized return. The firm may possess extensive experience and a competitive edge in marketing, lease-up operations, value-add redevelopment, or other aspects of real estate investment, development, or property management. Some firms excel in finance and acquisitions, focusing on a buy-and-hold strategy where they target promising opportunities and exit at an opportune moment without undertaking substantial development. At the other end of the spectrum, the sponsor may collaborate closely with a developer—or be a developer themselves—and construct new properties on acquired land. “Ground-up” development carries substantial complexity and risk, but also offers greater return potential than any other strategy.
While real estate investing strategies may not necessarily carry the same considerations with respect to market cycles and macroeconomic factors as geographic markets or property types (though a case can be made for aligning strategy to the business cycle phase), diversifying across strategies, from ground-up through buy-and-hold, can further balance upside and downside protection in your real estate portfolio. In general, EquityMultiple focuses on investments that offer a high degree of downside protection.
Conclusion: The Total Return Approach
Many asset managers and investment advisers adopt a “total return approach,” striving to combine assets that generate current income with those that offer the potential for substantial capital appreciation over an extended time period. EquityMultiple advocates pursuing this diversified approach as you build your real estate portfolio.
By diversifying across the parameters discussed above, you can combine income-producing assets with those offering capital appreciation potential. EquityMultiple aims to provide a spectrum of investment offerings across these dimensions to facilitate a total return approach, ranging from yield-focused cash management products like Alpine Notes to value-add equity investments for upside potential.
Thanks for reading—we hope you found this material useful. We’re happy to answer questions at [email protected].