Harry Markowitz’s Modern Portfolio Theory suggests that it is possible for investors to create a buffer against risk by investing in multiple different industries or asset classes to ensure that losses in one area of the portfolio are balanced out by gains in another. This is known as diversification, and it is essential to the creation of any good portfolio – it is no coincidence that Markowitz’s theory won him the Nobel Prize in 1990.
What diversification does is safeguard investors from the damaging effects of unforeseen events that impact the market. For example, if a political, social or geographical event has a negative impact on one area of the market, then those that have shares in exclusively that area are going to lose out; however, if the same event has a positive impact on another area of the market, then those with shares in that area are going to profit, therefore meaning that having shares in both areas is the best way to mitigate loss.
So what is the best way to properly diversify your portfolio? Well, to start with you need to ensure that you have shares in a range of industries that covers a good cross-section of the market; it is also advisable to build your investment in each area over time, little by little – investing lump sums up front can result in large and very sudden losses. But to properly diversify, you will also need to invest in different asset classes. David Swensen’s Yale Model of investment shows that investing equally in six different asset classes is an extremely good way to create a balanced and profitable long term portfolio.
Swensen also identifies alternative investments such as real estate as essential additions to any portfolio. Real estate is especially good for diversification as it creates a solid foundation, due mainly to the fact that it’s a tangible asset in an area of the market that tends to remain more or less stable. The only issue with real estate is that it traditionally requires large amounts of capital to invest in a property, therefore making it difficult to allocate smaller amounts towards real estate as part of an overall piecemeal spread of wealth.
This, however, is no longer true. It is now possible to invest in real estate with smaller amounts of capital via real estate crowdfunding with Bricksave. By purchasing only one part of the property and sharing the equity, you only need to deliver part of the overall cost, leaving you more capital to apply to other areas of your portfolio. What this also means is that you can now further diversify within the property section of your already diversified portfolio – i.e. investing in a range of different property types in different parts of the globe, ensuring that one real estate slump in one area doesn’t affect your entire property allocation. By adopting this approach you will be fully taking advantage of Markowitz and Swensen’s diversification blueprints for prudent investing.
February 01, 2017
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