Diversification for Real Estate Investors | Freelance Lifestyle, Finance and Entrepreneurship Blog

This is an edited version of my response to a question on the Bigger Pockets forum (a real estate investor site):

Diversification is a valuable strategy for investors. Investors focused on real estate can add safety to their portfolio by diversifying with real estate and financial assets.

Financial Assets

Diversify with stocks and bonds (though at these interest rates I prefer money market funds and a small amount of short term bond funds). Within stocks (for USA investors) some global stocks can be a sensible strategy (though there are reasonable arguments to be made for USA S&P 500 having lots of international exposure). For those outside the USA I definitely believe global diversification is important.

Other thoughts on diversification: Investment Risk Matters Most as Part of a Portfolio, Rather than in Isolation

Real Estate
It is also sensible to diversify within real estate. I am looking at buying real estate in a 2nd location, in a different sate (I am uncomfortable with how much of my assets are in real estate in 1 geographic location).

There are many good reasons to buy real estate locally – expertise in the market, ease of management… But from a perspective of diversification buying in a 2nd location can make sense (and then a 3rd…). You can also look at things like vacation rental (v. SFH rental, apartments, cheap v. expensive rentals…), business real estate (retail, office space…). You can use Real Estate Investment Trusts REITs (useful, for example, for those not interested or able to do business real estate directly). There are many risks to being geographically and type concentrated.

An easy way to see the risk to consider an investor with all vacation/airbnb rentals in 1 city. That city then passed laws that restrict or kill that business? The legal risk – local and state and federal tax law changes are real (and not just airbnb restriction law changes, that airbnb example is easy one for most people to see). Also the economy of that location or state could be harmed and you would be harmed (even if you did really well in a downward spiraling market the market forces may overwhelm you advantages).
 

House in Arlington, Virginia, see my post on Real Estate Investing in in Arlington, Virginia given Amazon’s Regional Office announcement

Diversification is a wise move to increase safety. But how you do that is debatable and not as easy as just wishing to be wisely diversified. Most people not on these boards would benefit from diversification by adding real estate to their investments (while many on these board probably could benefit by diversification with non-real-estate investments).

Warren Buffett on Diversification
 
Other comments on the board mentioned Warren Buffett’s comments on the benefits of concentration (the opposite of diversification). Warren Buffett’s argument against too much diversification basically boils down to him wanting to spend a lot of time becoming an expert on 10 companies he owns vs. buying some of 200 companies (as he doesn’t think anyone can really be an expert on 200 in addition to the problem of finding nearly that many great bargains). His statements on diversification in this manner was essentially a response to questions about comparing him to stock pickers from managed mutual funds (where they owned 100 or 200 or more stocks and he often owned huge amounts of under 10 – he also bought out companies completely so really he has over 10 but…).

Warren Buffett also believes just buying very diversified stock market funds (unmanaged with low costs) is a very good strategy for nearly everyone (excepting himself and a few others). Basically Warren Buffett says diversification is a good way to get average returns (if you can smartly beat the market over the long term diversification will dilute your ability to beat the market moving you to average). But for the vast majority of investors over the long term the reduced risk that comes with diversification is wise and pays off for them.

As with most things, diversification has advantages and disadvantages but most often a well diversified investment portfolio provides the best protection against the many risks individual investments face.