Every experienced investor knows that diversification is perhaps the most critical element of a successful investment portfolio. Diversifying an investment portfolio ensures that investors are distributing their risk to different products to safeguard their investment.
Think of diversification as a sort of balancing act, which increases the chance of maximizing returns because different investment portfolios will react differently to an adverse event. In simple words, it means that if you have invested in multiple financing products, it’s likely that a negative event will only affect a certain category of it. As a result, a diversified financing portfolio will make healthy returns compared to a single investment product.
You may also have heard that diversifying a portfolio can result in a lower return because the risk is mitigated. It’s just like saying that the return will be a zero-sum game because investors are not gaining as much as they could from a single high-flying investment product. While it’s true to some extent, there are almost countless ways to ensure a high return from a basket of investment.
Diversifying the Portfolio Using Real Estate
Since the industrial age, real estate is often thought to be the safest investment vehicles in the market. While we can certainly argue with the statement, it’s true that real estate is seen as a hedge against adverse market conditions. Starting as early as the stock market crash of 1929, real estate prices have not fluctuated as widely as other major investment portfolios.
Consider the Flash Crash of 2010 when investors are reported to lose $1 Trillion in a mere 15 seconds. It means that if you had invested heavily in the stock market, chances were that you would also lose big because stocks naturally move in the direction of the overall market trend. The risk associated with stocks and similar instruments is one of the main reasons to invest in real estate.
In the past, there were only a couple of ways that you could invest in real estate. The easiest of these was to buy a house and hope that it would continue to increase in value; however, few would take this investment option as buying a house is costly. Even if you were rich, you would buy a nice big costly house that was consummate with your living standards. In the end, everyone would hope that the investment yields positive inflation-adjusted returns in the long-run.
Luckily, the digital age has introduced a variety of real estate investment options that are as easy as buying a stock. Nowadays, there are REITs, ETF’s and other simple real estate financing instruments that anyone can buy to prosper. These types of real estate investment products allow investors to invest in mega commercial projects and huge real estate ventures.
These investment products allow investors to buy real estate to hedge against the risk in other financial instruments. For investors who have more cash to spare, they can buy a physical real estate and invest in real estate instruments to get cash flows from both types of financing. Of course, there are some disadvantages to these digital investments as it may be difficult to convert an asset into cash and cash into an asset due to liquidity issues. Still, it seems that the benefits far outweigh the potential drawbacks.
To better understand your options, let’s look at some of the popular investment avenues followed by real estate investment types:
Major Types of Investment Products
- Stocks: These are the most common type of investment channel used by most investors. Investors make money when the value of the stock goes up. Long-term investors also gain profit when the company pays dividends to investors. The stock market is full of opportunities but there is a risk of losing cash instantly if the market fails.
- Bonds: Bonds are borrowed by the investor at a certain interest rate. Basically, investors are giving a loan to the government to use their money and give them part of the profit as an internet. Bonds are often considered zero-risk and a safer investment because governments of well-developed countries rarely default. Still, the rate of return is much less than the stock.
- Mutual Funds: Mutual funds are investment funds that invest in a diversified portfolio of financing vehicles. They are professionally managed by a fund manager. When a mutual fund makes money from stocks, bonds, and other investment channels, investors are paid accordingly. While mutual funds normally provide better returns than bonds, you are likely to share a percentage of your profit with the fund manager.
- Index Funds: An index fund usually mirrors and tries to copy the performance of the underlying market. Since most investors cannot buy every stock in the S&P 500 index, investing in an index fund that tries to copy the exact movement of the S&P 500 is a good choice. The obvious disadvantage of index funds is the potential downfall if the underlying index goes down.
- ETF: Exchange-traded funds are similar to index funds as they are also created to mirror the performance of a benchmark index. The main benefit of an ETF is the cheaper price because ETFs are not managed by a fund manager. In addition, anyone can buy and sell ETF instantly just like stocks on the stock market instead of monthly transactions based on the price at the end of the month.
- 401K Investment: These are the ones made by most Americans to save money at their retirement. The savings account allows employees to divert a portion of their salary into long-term investments. This is usually made on a choice of mutual funds. In order to encourage contribution, some companies match part of employee contribution up to a certain limit.
Real Estate Investments
Despite the prevalence and the variety of investments, investing in real estate is still regarded as the safest type of financing. In recent years, a variety of real estate investment instruments have been introduced to generate greater public interest. The purpose of these investments is to offer the public an opportunity to reap benefits from the construction of large-scale commercial and residential projects without investing huge amounts of cash. Here are some examples:
- REIT: Among the most popular real estate investments are REITS, real estate investment trust that invests in real estate properties. Investors can buy securities in public and private REITs. Public REITs are traded publicly at the stock exchange, while private REITs are traded in unregulated markets.
- LP: Nowadays Limited Partnership financings have also attracted attention. These are privately owned real estate developments, which are aimed at building condominium or residential projects. Just like private REITs, Real Estate LPs are not traded on the exchange and the terms of a partnership are similar to the terms of the limited partnership agreement.
- MIE: A mortgage investment entity is another type of private real estate financing vehicle. MIE is usually referred to as a mortgage investment corporation, which lends money to borrowers who can’t borrow money from conventional sources. An investor purchases security issued by MIE, and they earn a profit from the interest rates earned by the MIE on its portfolio of mortgages.
- Real estate investment is likely the key to balance returns and risks associated with financing products. Hopefully, this brief overview is likely to offer investors an opportunity to think about how they can effectively invest in different types of real estate instruments. If you are looking for a more in-depth guide and are just starting down the real estate investment path check out The Kay-Grant Group’s real estate investment guide.