Diversification for Real Estate Investors

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).

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.

Related: Using Annuities as Part of a Retirement PlanShould I Sell or Keep My House When I Become a Nomad?Looking at Real Estate in This Challenging Investing Climate (2015)Use FI/RE to Create a Better Life Not To Build a Nest Egg as Quickly as Possible

Using Annuities as Part of a Retirement Plan

Annuities have a bad reputation, with a history that makes that bad reputation sensible. The main problem is the high costs (and often hidden costs) of many annuity products. Combine with large sales incentives this has led to annuities being abused by sales people and financial companies while providing poor returns to investors.

However the attributes of annuities fit a specific part of a retirement plan very well. Overall I am a big fan of IRA, 401(k), HSA – all of which provide the investor with control over their own financial assets. And I still believe they should be a large part of a financial plan.

In order to save for retirement, we need to start young and save substantial amounts of money to live off of in retirement. Retiring early requires that investments provide income to live off of for an even longer time.

Pensions provided an annuity (a regular payment over time). Social security (in the USA, and other government retirement payments internationally) provide an annuity payment.

A rough rule of thumb of being able to spend approximately 4% of the initial retirement investment assets (given a portfolio invested in USA stocks and bonds) gives a starting point to plan for retirement. That 4% rule however is not guaranteed to work (especially if you live outside the USA or retire early). In fact relying on it today seems questionable in my opinion (not only even if you retire at 67 in the USA (given the current seemingly high values in the stock market).

The best roll for an annuity in retirement planning in my opinion is to serve as a protection against longevity. The longer you live the more risk you have of outliving your investment savings. Life annuities have the benefit of continuing for as long as you live.

One of the disadvantages of a life annuity is that the principle is not yours to leave to heirs. That is a fine trade-off for protection that you have enough to live off of in most cases. And I wouldn’t suggest having all of your money put into an annuity so if leaving assets to heirs is important you can just factor that into the balance of how much you put into the annuity down payment.

John Hunter with lake and mountains in the background

John Hunter, Bear Hump trail, Glacier-Waterton International Peace Park

It is possible to have the annuity pay for as long as either spouse lives (so if that is a concern, as it would likely be for most married couples, that is a good option to use). The payment will obviously be less but not by a huge amount (though if one spouse is many decades younger, then the amount can be substantial).

An annuity payment is calculated based on projected investment returns and your life expectancy. The older you are the larger a percentage of the initial deposit you can expect as an annuity payment. Something like 5.5% if you are 65 today may be reasonable (this will change as investment projections, especially interest rates, change). So one thing you will notice right away is that is much greater than 4%. And that shows one advantage of using annuities.

Why is the annuity able to provide payments greater than 4%? A big reason is that the insurance company can balance the payment based on a large number of people. And many of those people will die in 10 or 15 years. That allows them to retain the assets they were investing for those individuals and still continue payments for those people that live for 25, 30+ years.

Continue reading

Getting Started Early on FI/RE

image of the cover of Daredevil #181

I started adopting the mindset that set me on the path for FI/RE (Financial Independence/Retire Early) when I was very young. I collected baseball cards when I was a kid and added comic collections when I was a bit older kid.

Early on I was paying attention to the investment potential. I enjoyed not just the collecting but also the idea of making money by buying something and then selling it later for more money (which is the fundamental idea of investing). It came naturally to me.

I never much liked spending money on something that lost its value. For some things, like ice cream, I could happily spend my money even though I would soon have nothing to show for it. But more often I would rather buy something I could enjoy and also believe I would be able to sell later at a higher price.

image of Watchmen comic cover

When I started actually trying to sell baseball cards for money I learned about he difference between reported “value” and the ability to get cash for what you owned. Not only can’t you sell items to a store at the “value” reported in pricing guides you often couldn’t sell them at all (they didn’t want the items at all).

In high school I started renting space to sell at shows. There you were selling to the public (or other dealers). I learned vivid examples of the challenges of turning assets into cash. And I also learned about the weaknesses in the economic ideals such as the market being efficient. I saw how often the very same product (the same baseball card) for sale in the same hall would have very different prices (over 100% more was not uncommon) and the sales were often not close to the best buys. The friction in this situation was much smaller than the typical purchase (all the items were in the same room, just a little bit of walking created the friction).

Continue reading