Rethinking Diversification: How to Prepare Your Portfolio in Case of Another Crisis

If you’re like most investors, you’re probably invested in the stock market through a retirement account or individual brokerage account. But what if I told you that almost every major institutional investor earned higher risk-adjusted returns than you by following a different investment strategy?

Major institutional investors diversify their portfolios across both public and private investments. However, until recently, everyday individual investors were barred by regulations to access private markets. By definition, private investments were not available to the public. Now, advancements in technology and the introduction of new federal regulations allow retail investors to invest like institutions.

Traditional Portfolio Theory

Although investment strategies may vary in the twenty-first century, most investors’ portfolios look quite similar, with the majority allocated to a mix of public stocks (60-70%) and the rest to bonds. For many years, this allocation has been considered the norm.

This idea was first introduced by economist Harry Markowitz in 1952. Known as “Modern Portfolio Theory”, Markowitz’s approach provides a way for investors to maximize returns for a given level of risk by diversifying across different assets.

Today, Markowitz’s findings are generally used to justify the standard portfolio allocation model, whereby your investment portfolio should be a balance between publicly-traded stocks and bonds, starting with a ratio typically of 70:30, and then transitioning away from stocks and into bonds as you get older. The allocation to public equities is thought to offer sufficient diversification across industries, geographies, and firm-specific risks, while bonds are generally believed to act as a portfolio-level diversifier and risk mitigant, since fixed-income returns have historically been assumed to be inversely correlated with stocks.

Until modern day, this has held true for the everyday investor. Throughout history purchasing a basket of stocks offered more diversification than it does now. In fact, this was why the stock market developed in the first place — so that shareholders could mitigate their risk by spreading out their exposure. The Dutch East India Company, the world’s first publicly traded company, became public for this reason. Sailing explorers into unchartered territories in wood boats across the world turned out to be a very dangerous exercise in the early 1600s!

Of course, investors who lost substantial wealth in the stock market crashes of 1929, 1973, 1987, 2000, and 2008 quickly learned that diversifying among stocks alone does not offer sufficient risk mitigation. This is true of any asset class. Although the stock market has recovered from these crashes with time, I always felt strongly it was vitally important to give individual investors access to the same risk mitigation strategies previously only available to institutional investors. That’s why I created Fundrise — to offer others the opportunity to diversify outside of the public markets, thereby giving them the opportunity to earn potentially better returns, mitigate their risk, and properly plan for the financial stability of their families.

A New Approach

Although in the early days of the stock market, spreading your money across a small basket of stocks meant you could sleep easy at night, in recent years, this couldn’t be further from the truth. As correlation not only among stocks but also between stocks and bonds has increased, the diversification potential of the traditional portfolio has decreased. This is due to a number of reasons, including advances in trading technology and the rise of index investing, to name a few. A highly correlated portfolio allocated only to public stocks and bonds risks dramatic losses in a downturn.

A wealth of evidence suggests that private investments — not traded on a public stock exchange — may boost portfolio performance while mitigating risk. However, there is a tradeoff. Investors give up short-term liquidity in exchange for these higher potential returns. While some investors cannot afford to allocate a percentage of their investments to less liquid assets, it can be a fit for long-term investors.

Many of the most successful institutional investors have consistently protected their downside and earned higher returns by adding private market assets like real estate to their portfolios. For example, the private investment holdings of the California Public Employees’ Retirement System generated 20-year annual net class returns of 12.3% versus 8.2% for its public equity holdings – an approximate 400 basis point differential.

A recent Pew study found that public pension plans have more than doubled their alternative investment allocations over the past decade–from 11% to 25%, on average–and now hold a collective $255 billion in private equity assets. Moreover, in a survey conducted by the McKinsey Global Institute (MGI) among institutional funds representing nearly $7.5 trillion in investable assets, more than three-quarters indicated that they are “likely” or “very likely” to enhance their private equity investing capabilities over the next five years.

The main reason I see individuals without exposure to alternatives boils down to lack of education on the subject, mostly due to the fact that most people have historically not had access to alternatives.

Access Through Technology

We started Fundrise because we knew there was a better way to invest, but that the majority of investors couldn’t get access to quality private alternatives. I have seen private real estate outperform all my other investments, yet public investors did not and could not invest. Recent regulatory changes, most notably Regulation A+, have finally made access to private investments possible. By building the first private market real estate investment platform, we’ve now made it possible and efficient for the everyday investor to have a portfolio like the most sophisticated, multi-billion dollar investment funds.

By combining technology with new federal regulations, Fundrise brings the once-unattainable world of private investments directly to you. Technology has changed almost every aspect of our lives in the 21st century, it’s about time your investment strategy caught up.

 

Ben Miller is Co-Founder and CEO of Fundrise. With over 18 years of commercial real estate experience, Mr. Miller is an innovator and champion for the everyday investor, focusing on the Fundrise mission to democratize access to real estate investing. Stay up to date with the latest from Fundrise through their social channels: Facebook, Twitter and LinkedIn.

 

Past performance is no guarantee of future results. Any historical returns, expected returns, or probability projections may not reflect actual future performance. All securities involve risk and may result in partial or total loss. While the data we use from third parties is believed to be reliable, we cannot ensure the accuracy or completeness of data provided by investors or other third parties. Neither Fundrise nor any of its affiliates provide tax advice and do not represent in any manner that the outcomes described herein will result in any particular tax consequence. Prospective investors should confer with their personal tax advisors regarding the tax consequences based on their particular circumstances. Neither Fundrise nor any of its affiliates assume responsibility for the tax consequences for any investor of any investment. The publicly filed offering circulars of the issuers sponsored by Rise Companies Corp., not all of which may be currently qualified by the Securities and Exchange Commission, may be found at fundrise.com/oc.