Portfolio Diversification - Does It Matter?

28 February 2017

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Whatever your attitude to risk or the shape of your investment portfolio, most of us have at least one thing in common: we don’t want to be left over-exposed in volatile and uncertain market conditions.  

Property’s reputation as a diversifier is as strong as ever. We were reminded of this late last year. IP Global asked 500 investors why they were drawn to property investment – and the benefit of this asset class as a safety net was one of the most popular reasons cited. The responses revealed how property is seen as a go-to diversifier; investors are looking for options that are above the fray of other asset classes and indices – to bring an added level of security to their portfolios.  

There is, of course, much more to property than simply a second canopy in case your stocks and bonds go into freefall. Whether your aims are long-term capital growth, or income generation (or a combination of the two), the right property investments can certainly add real value. 

But specifically when it comes to risk-balancing, evidence certainly suggests that property deserves its reputation as a lynchpin of any investment portfolio. Here, we’ll unpick the reasons for this - and explain how to invest with effective portfolio diversification in mind.  

WHY DIVERSIFICATION STILL MATTERS  

As investors, we are all at the mercy of ‘events’: whether good or bad, foreseeable or completely out of the blue. Those events could affect specific markets, indices, industry sectors, entire geographic regions or individual companies. Diversification is a tried and tested risk-mitigation strategy that tries to address this. The aim is simple: to invest in a wide range of assets and asset classes to ensure that if (and when) events unfold and their associated risks arise, not all investments within the portfolio are affected the same way.  

It might be a familiar strategy – but is it still relevant? 

For one thing, “disruption” looks set to be as much of a buzzword for this year and the foreseeable future as it was for 2016. While disruption can present opportunities (think tech stocks, for instance), the start-of-year outlooks for 2017 are laden with a longer-than-usual roll-call of potential disruptive headwinds. A possible move to protectionism in the US, uncertainty over how long China will maintain its stimulative policies, the ongoing Brexit saga…the list goes on. 

Diversification might be the oldest strategy in the book – but it’s actually more relevant than ever. 

Why property? 

There are lots of sound reasons for including property as a diversification element in your portfolio. Here’s a roundup of the main ones. 

Firstly, it’s one of the few truly effective diversifiers left. Diversification is an easy concept to understand, but it can actually be pretty hard to put into practice – and evidence suggests that it’s getting harder.  

A portfolio is diverse if it contains a proportion of assets that are weakly correlated with the rest; in other words, the prices of those assets move separately from the remainder of the portfolio. To take equities as an example, a couple of decades ago an investor with a large stake in the S&P 500 might have looked to another major stock market such as the FTSE 100 or DAX for diversifying assets. In all likelihood, such an investor would have been able to identify suitable candidates. But as just one example, you only have to look at how tightly correlated the US and UK equity markets have become since 2000 to realise just how interconnected the world’s markets are now. 

Globalised markets and instant trading are driving this interconnectivity. You’ll find, for instance, that no longer is it the case that commodities move completely independently of equities. What’s more, as Blackrock pointed out in its 2017 outlook, we’ve even seen the direct negative relationship between stocks and bonds get weaker over the last few years – making it harder to go down the traditional route of using bonds to buffer equity market swings. 

It means that so many markets are a direct proxy for the same ‘events’ – making it harder to pinpoint investments that are driven by distinct factors and which move in ways independent of the rest of your portfolio. Property is one of the few asset classes that still fits the bill as a diversifier. 

Distinct value drivers  

Property still has a low correlation to stocks, bonds and commodities. Yes, it’s affected by the wider economy, but it’s a lagging indicator, i.e. the effects of ‘events’ tend to take longer to feed through to real estate compared to most other markets. It moves in a different way to other asset classes. Its fundamentals – which often include population growth and an inelastic supply side that fails to keep up with demand – are unique to this particular market.  

It’s one of the reasons why residential property tends to trump commercial real estate as a diversifier. While shocks affecting the wider economy can often be felt in areas such as demand for office space, those reverberations tend to be much weaker in the housing market. 

It’s also the case that each particular residential property market has its own characteristics. What’s true of Berlin might not apply to Frankfurt; the factors driving growth in booming areas of South London might apply differently in other parts of that city – and certainly, the UK.  

No two real estate markets are the same – and it's these distinct value drivers that enable property to bring a welcome risk-reduction element to your portfolio. Property – and, more specifically, distinct property markets have a ‘rulebook’ all of their own.  

Diversification, capital growth, income: property brings all three to the table 

Investors want a safe haven – but one that’s going to actually work for them. With regards to capital growth, and taking the London market as an illustration, the graph below demonstrates how property not only holds its own – but has significantly outperformed other key indices over the long-term. 

And with this comes the other key benefit of property: that of a reliable income yield through rent. Property performs two important roles simultaneously: it offers diversification while making up a valuable ‘working’ element of your portfolio.

Comprehensive Asset Comparison Table

How to invest in property with diversification in mind  

When it comes to diversification, not all property investments are created equal – and what’s ideal for one investor might not be for another. Here’s how to weigh up your options: 

Look at the big picture 

Beware of agencies who are quite obviously trying to shoehorn whatever investments happen to be on their books into your portfolio.  

A thorough understanding of your current situation and goals should always be the starting point. 

What is the current makeup of your portfolio? What risks are you faced with – and what characteristics should a potential property investment feature in order to counterbalance that exposure? What’s your end-goal in terms of capital growth? What are your income requirements? 

IP Global’s approach involves exploring all of this with you.  

Avoid the ‘home bias’ 

Would you invest in Rio Tinto solely on the basis that you happened to live in Melbourne? Probably not. Yet when it comes to real estate, there can often be a tendency to automatically favour homegrown markets.  

You’ve identified the specific criteria you require from an asset with a view to diversifying your portfolio. In all likelihood, there are property investment opportunities out there that will meet those criteria. Applying the same logic you’d apply to any other asset class, there’s no good reason to suggest that the best opportunity for you will automatically be on your doorstep. 

Look for global and local expertise 

In part, the illiquidity of property helps explain the existence of this home bias. Real estate is, after all, a medium to long-term investment, where a hasty, unplanned exit can result in a serious hit on returns. Most investors are well aware of this; they want to get it right – so some might limit their search to markets they feel close to. 

Yet those investors who stick to home turf are automatically starting to compromise. They are effectively putting geography before the merits of the investment; they risk ‘settling’ for an investment that doesn’t fully meet their diversification criteria – not to mention ruling out benefiting from any foreign currency play that might be in their favour.  

But add expertise into the mix, and there’s actually no need to compromise. 

With the right help, and using their diversification requirements as a starting point, there’s no reason why investors shouldn’t take a global view; comparing and contrasting a diverse range of markets to see which best meets those criteria. Coupled with this should be local expertise; eyes and ears on the ground to pinpoint the most appropriate opportunities.


 

Now that you understand the importance of property in your diversification strategy, you might want to learn from other people mistakes and find out which pitfalls to avoid. IP Global Director, George Radford, offers his insights for aspiring investors.

What To Avoid When Investing In Property?

 


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Richard Bradstock

Written by Richard Bradstock

With over 13 years’ experience in global property markets, Richard was the second employee of IP Global in the Middle East, joining as a consultant. He has rapidly progressed over the last 6 years and now heads up the GCC region whilst offering clients advice on diversifying and building portfolios in international property.

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