At Fundrise, diversification is at the root of many of our most important conversations. There’s a lot to say, a lot to praise, and a lot of different ways to say it — a diverse conversation about diversification.
However, for the sake of this article, we’ll be talking about diversification with a specific, practical meaning: toinvest in holdings both inside and outside the standard markets. Namely, outside the stock market. That means a well-diversified portfolio will often hold bothstocks and alternative investments.
Why? Holdings that belong to the same market tend to share similar behavior — they have high correlation to each other. When you add alternative investments on top of your stock holdings, you potentially lower your portfolio’s overall correlation.
And as many people know, lowering correlation also lowers risk. If, for example, the stock market takes a serious dip, a portfolio that also holds real estate will potentially suffer less than one that only holds stocks. Real estate is often less sensitive to many of the influences that can cause volatility in stocks.
But that idea of diversification is just the beginning.
In reality, it’s an ever-evolving topic and deserves regular exploration. It’s often not so cut-and-dried as “Add x, protect yourself from y.” And for sophisticated investors it’s not solely about insuring your portfolio by going beyond stocks — it has the potential to grow your portfolio too.
Many people might appear well-diversified but in practice are missing out on some of diversification’s key benefits. This article is designed to look at several truths about diversification that are likely unknown to many investors. Even seasoned ones.
After all, diversification isn’t intended to make your portfolio simpler — by definition, it adds more moving pieces, and that means both more complexity… and more potential for growth.
1) Diversification is most valuable over the long term — not just during a downturn.
As outlined above, one of the main narratives around diversification is that it proves its primary value when one market has a downturn. As common knowledge says, if you have a portfolio with holdings that correlate to a variety of markets, parts of your portfolio will be resilient when one segment dips.
While that’s all true — and crucial — it’s also an over-simplification. Diversification offers real value all the time, not just during a crisis. Investors who don’t understand the full scope of its value might unintentionally be leaving some money on the table.
Diversifying beyond stocks helps improve your overall investment performance on an ongoing timeframe, by balancing volatility on a daily basis, not just during a dip in market performance.
It’s possible to diversify your investments in a way that your portfolio’s overall behavior surpasses the performance you’d expect from a narrower range of investments. Again and again, portfolios have shown evidence of how long-term diversification boosts returns overall. (See the chart lower in this article to look at a specific example.)
But to realize that benefit, your diversified portfolio needs time and the opportunity to develop through multiple phases of the market, so the law of averages can do its work.
Investors who want to reap the full value of diversification have to preserve it for the long term — not just when they think there’s a downturn on the horizon. Diversification’s highest potential isn’t when it’s used in preparation or in reaction to market behavior, but as a core, constant tenet of smart investing.
2) Just because an investment seems unique doesn’t mean it’s your portfolio’s missing piece.
It’s easy to think that an investment looks like a fantastic vehicle for diversification because it seems significantly different from anything else in your portfolio.
But appearances can be deceiving, and some old assumptions about diversification have been debunked.
For example, it’s been shown repeatedly that the performance of international stock markets — despite thousands of miles of geographical separation — have a higher correlation to American markets than many investors might expect. And often this occurs during bear market periods — exactly when you’d think you’d want diversification the most.
Sometimes a more important factor in assessing an asset’s correlation isn’t the asset type itself but the structure of the market to which it belongs.
That’s why diversifying outside of stocks is so important — you push your investments beyond a public market — and why something like private market real estate can offer benefits that international stocks or even public real estate holdings cannot.
For example, in some situations, the behavior of a public REIT is more likely to correlate with the Dow Jones than with a private equity real estate fund — even though both the REIT and the private equity own the same asset type. Public markets are potentially more sensitive to the same influences automatically, even if their underlying assets seem quite different.
Don’t let an investment opportunity fool you because it appears exotic or rare. Be sure to dig deeper into your potential investment and ensure that however it’s structured will make it correlate to markets in the way you expect.