Why diversify?
Most investors know diversification is classic conventional wisdom in investing, but can they say precisely why?
Every investment has some level of reward and some level of risk. Every investor does their best to maximize reward and minimize risk. The two aspects tend to exhibit a direct relationship — that is, as the expected reward of a given investment increases, the associated risk also increases. Unfortunately, a higher level of risk generally lowers the probability of capturing the full expected reward.
Diversifying the smart way – what’s the best approach?
If you limit yourself to low-risk investments, you’ll tend to limit yourself to low overall rates of return. The approach that savvy investors take is selecting a mix of investments for their portfolio — including some higher growth/higher risk —and combining them in a smart way so that some of the fluctuations cancel each other out. This approach tends to result in producing a relatively higher average rate of return, with less of the harmful fluctuations.
First, some scientific theory
There’s an important body of economic research pioneered by Nobel Laureates Harry Markowitz and Bill Sharpe referred to today as Modern Portfolio Theory, and it looks at the science of risk-efficient portfolios.
Picture every possible investment all plotted on one chart quantifying their risk along the X axis and their reward along the Y axis. Some investments will appear far too risky with their level of reward, while other investments will offer an appealing level of reward for risk taken. The upper limit of this latter category will form a line that follows a familiar curve referred to as the efficient frontier.
It can be difficult to accurately predict which investments will fall directly on or near the efficient frontier and which will fall below it. This is where diversification as a strategy comes into play.
Smart diversification yields risk-efficient returns
Take two hypothetical investments: Investment A has a moderate risk/reward profile, and Investment B has a relatively higher risk/reward profile. You might guess that a portfolio employing a 50:50 mix of both investments would average out to a risk/reward profile at the midpoint, but statistically speaking, it’s more likely an equal allocation between the two investments yields a lower level of risk for the same level of reward.
Better-than-average reward, lower-than-average risk: How is this possible?
Assuming the year-to-year performance of Investments A and B are not perfectly in sync — in other words, the great years and the not-so-great years for Investment A are offset or don’t correspond perfectly to the great years and not-so-great years for Investment B. We refer to this relationship as a negative covariance.
In a portfolio with a 50:50 allocation between two investments with a negative covariance, the overlapping great and not-so-great years will tend to skew the combined average risk level lower than taking a straight average of the risk levels of the two investments independently.
This statistical outcome is the reason the efficient frontier is a curved line instead of straight, and diversification is a powerful tool for crafting an investment portfolio that’s optimized to work within the statistical laws of nature.
More choices = more opportunities for diversification
You look to FNRP because we’re a leader in the industry when it comes to necessity-based real estate, a strategy which, we believe, already takes a lot of risk off the table when compared to other investment types such as ground-up development or other asset types such as office. You count on us to be extremely selective in which properties we invest in. Click the link below to get access to our deals.
Further reading: Harry Markowitz. “Portfolio Selection.” The Journal of Finance, Volume 7, No. 1, 1952, Pages 77-91
