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.
In order for people to appreciate the importance of diversification, it is essential to understand first what it effectively means. Diversification is an investment technique used to reduce risk by allocating investments across various financial investments, industries, geographies or categories. It aims to maximize returns by investing in different areas that won't all react the same way to the same event.
Although diversification does not guarantee against loss, it contributes heavily is in achieving your financial goals and minimizing risks at the same time. A fully diversified portfolio that includes a number of varying assets remain the best option to ensure good returns overall. This strategy has even been encouraged by academic investors working out of universities (see the Yale Endowment Model for an example).
For example, if a political, social or geographical event is having a negative impact on one area of the market, investors that own shares exclusively in this area might be severely impacted. In a similar way, if the same event has a positive impact on another area of the market, shareholders in that area will benefit by having shares across both areas and therefore will mitigate loss,
So what is the best way to effectively 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.
To make your diversification worthwhile, 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 remains a tangible asset in a market area that tends to remain more or less stable. The only issue with real estate is that it traditionally requires large amounts of capital investment upfront that makes 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 with 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 existing 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.
July 17, 2018
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