One of the first things people tell you about investing is that you must diversify. And by people, i mean your Uncle Ralf, who took a finance class once. Then comes the proverbial “Don’t put all your eggs in one basket” accompanied by the mandatory wag of the index finger. After you put some thought into it you realize that Ralph might be on to something here. It’s commonsense – when you put all your money in one thing, if that thing goes bust so do you. So spread your money around and while you might not make as much, you won’t lose as much either.
Aspiring real estate investors and experienced clients alike always bring up the diversification question during our conversations. So in this post I want to go over two main types of diversification. The first type is diversification between different asset classes. For instance, you can invest some of your money in real estate, another portion in stock market mutual funds and the rest in CDs. The second is diversification within the same asset class. As an example, if you invest in real estate you might spread your holdings in different locations. Or you can purchase a mix of multifamily and single family properties or commercial and residential assets.
But whether you diversify between or within asset classes, the principal at work is the same. Diversification at its very core is about hedging your bets by spreading the risk over assets that will counterbalance each other. If the value of an asset falls, a well diversified portfolio will have assets in it that will gain or hold steady therefore softening the blow. And of course when things are good you just aren’t making as much as you could for the same reason. But since fear of loss is a much stronger motivator than the desire for gain, that’s a trade most of us are willing to make. In many ways, it makes us feel prudent, measured and restrained.
So is diversification a good idea? Does it have to be a necessary part of every wise investment plan? The short answer is: It’s complicated.
Let’s start by tackling the extremes. First, no wise investor would subscribe to an investment strategy that’s categorically against any type of diversification. If someone is trying to persuade you to invest everything you got on this one thing, run away as fast as you can. I don’t care how much of a “sure thing” you think it is. You are two M&Ms away from losing all your money. Then there’s also such a thing as extreme diversification. That’s when you’re so terrified of risk that you diversify and complicate things to no end only to discover that you could have just kept your money under the mattress and achieved the same thing. Except that you paid a guy in a suit and tie lots of money to accomplish nothing.
But what about the middle of that spectrum. Before I tell you how I really feel about it, I’d like to share some wisdom with you:
Diversification is protection against ignorance. Wide diversification is only required when investors do not understand what they are doing – Warren Buffett
Wide diversification, which necessarily includes investment in mediocre businesses, only guarantees ordinary results. – Charlie Munger
Deworsification – Peter Lunch
An investor should never have anything to do with that which he does not understand. Tell me what sense does it make to invest in several other businesses or assets you don’t understand to alleviate the risk from the original asset you invested in without understanding it? My thesis is that there are much more efficient ways to mitigate investment risk than diversification.
First, get educated to the point that you understand the risk-return dynamics of the investment. I’m not talking about being sold by advertorials that only shed positive light on whatever they’re selling that week. I’m referring to real education that will show you how that investment will make money, what’s the worse that could happen and what you can do to minimize that risk. That could come from the Institute for Hard Knocks and Past Failures or from a trusted advisor/mentor who can offer you their 10,000 feet view. It’s crucial that you get to know the real risks because once you do you can choose to either walk away or move forward after you do something to minimize it. The alternative is to eliminate this vague idea of “risk” by putting some money over there in case I get cleaned out here. That’s not risk mitigation. That’s reaction to fear and no way to invest successfully.
The biggest problem with diversification is dilution. In real estate investing as in most areas of life we achieve important things by executing well defined plans with focused intensity. In the wide majority of cases, our capital, our income and our time are limited. Most of us don’t have enough capital or income to try every investing strategy ever created. So when we take our limited resources and we spread them out to a number of different investments, we dilute it to the point of making it ineffective. So we end up with what Charlie Munger called “ordinary results”. And let’s be clear about it: When it comes to investing for retirement, ordinary results usually means working till you can’t to make ends meet. Listen, I’m not suggesting that you pick an investment strategy for your retirement and put all your money into it to avoid dilution of your capital’s power to achieve great things. What I am suggesting is that there has to be a primary strategy that you adhere to and execute over long periods of time and that most your capital needs to go there. You must keep some of that capital in cash reserves so you can sleep at night. You should have some of your capital in other investments (i.e. index funds) . What you shouldn’t do is to take your capital and split it 100 ways. If your primary aim is to preserve your savings, the best strategy is to keep your money in your savings account.
The absolute best risk mitigator is Quality. This is especially true for real estate investing. When your primary focus is the selection of quality properties in great locations that leads to quality tenants that pay rent on time and treat your properties like their own. That in turn leads to lower turnover, less make ready and lower risk of default and evictions. By lowering turnover and reducing the risk and cost of property damage, defaults and evictions, you have reduced risk to its lowest level. And here’s the beautiful thing: At the same time, you’ve increased realized returns. Beats diversification like a red-headed stepchild, doesn’t it?
Diversification can be good when it brings an additional dimension to your investments while minimizing risk. For instance, by purchasing expensive properties in excellent areas rather than your standard assets, you accept a lower return for a lower risk profile. But most importantly, you give your portfolio another dimension by adding an asset that would perform better during an appreciating market. This way you add the potential of appreciation capture to your investments in addition to reducing risk. Diversification is useless and harmful when it’s done for its own sake. For example, a portfolio with some investment properties in good locations and others in bad locations would be diversified location-wise but it would hurt your chances of success tremendously.