How to Keep Wall Street Diversification Rules from Slowing Your Wealth-Building as a Passive Investor

by | Dec 8, 2023 | Real Estate Syndications

Whether you have a 401k/IRA or financial advisor, you’ve gone through the mind-numbing exercise of picking or confirming the holdings in which you wanted to invest in various sectors from large cap (large companies like Apple) to mid cap (medium size company like Etsy) to small cap (small companies like Dave & Buster’s) to fixed income (various bonds) to international (like Swatch) to…..many more!

It’s a fact that stocks/index funds and the various sectors of the market can be very volatile. Combined with the fact that a segment that performs well one year is often a laggard the next year, Wall Street has developed diversification models that call for spreading your investments over as many segments as your goals and risk tolerance call for. Then, your portfolio is weighted by sector, e.g., 25% large cap, 15% mid cap, 10% small cap, 10% international, 5% alternatives (like Real Estate) and 35% fixed income. Portfolios of course can include even more investment classes, like precious metals (eg, gold).

Here’s the problem, I will often have investors tell me they (or their financial advisor) want to limit their real estate exposure to some small percent (like 10%) using the Wall Street model of diversification. Unfortunately, that often leads to investors missing out on wealth growth because they are applying the Wall Street allocation model inappropriately to a non-Wall Street investment. Read on to see why and how to proceed in a better way….

Why Broad Asset-Class Diversification Makes Sense for Stock Market Investments

When you have various classes alternating between strong performance and lagging performance with no way of knowing the direction from year to year, broad diversification makes a lot of sense. It makes even more sense when you delve into why this variability exists. There are three drivers that create the variability of stock market/index performance:

1) Fundamentals

First, there are market fundamentals, ie, the economy. Based on whether overall employment is good or bad, whether interest rates are increasing or decreasing, whether GDP is increasing or decreasing, these can all impact every market sector both positively and negatively. Even if a company is doing well, its stock price can be pulled down by a poor economy.

Then there are company fundamentals that are the biggest drivers of the value of stocks and sectors. A company that has increasing sales, increasing earnings and competitive advantages will see an increase in stock /sector price over time. However, a poor economy can still cause share declines in companies and sectors in the short term even though performance for the stock or segment is strong. That’s why it’s often frustrating when investing in high-flying segments like the semiconductor segment that will benefit greatly from AI. Take high flyer Nvidia that has superb growth in revenue and profits, but went from $337/share in November 2021, to $111 in October, 2022, to $458 in December, 2023. Wall Street helps investors create diversified portfolios that include other stocks/sectors which will help smooth out your performance so the lows are higher and the highs are lower, taking investors off the extreme roller coaster ride!

2) Technicals

This gets rather technical (no pun intended), but suffice it to say that there are large computer algorithms that trade based on the levels that a stock or sector index fund hits. For example, when a stock or sector price shoots up significantly more than the fundamentals would suggest in a short period of time, computer programs will sell and cause the stock/sector prices to go down. On the other side, a stock or sector going down in price can hit a price point where the computers come in and start buying, driving up prices. Importantly, whether the company has strong fundamentals or not, technical trading is another factor that drives performance that is variable and different than one might expect.

3) Investor Sentiment

Sometimes there are what’s called “animal spirits” that take hold in a marketplace where stock/sector performance is driven by how investors feel, either overly optimistic or overly pessimistic. Of course, optimism is more predominant, like the irrational exuberance that is exhibited before many crashes, like 2009, where stock prices were driven much higher than the fundamentals we discussed earlier would justify followed by a painful downturn. Of course, when a market crashes, the sentiment goes more negative than the fundamentals justify. These spikes in either direction will impact some stocks/sectors more than others, thus another reason to broadly diversify.

Why Broad Asset Class Diversification Can Be a Negative for Real Estate Syndications

Investors in real estate syndications typically spread their monies in apartment complexes, self storage, medical offices, business offices, warehouses, mobile home communities and more (Kidding, No They Don’t)! There are several reasons why the need for broad diversification with real estate syndications is much less and can even be a negative:

  • With real estate syndications, the investment is made in a property or small group of properties where the fundamentals, i.e. the property performance(s), totally drive the value. There is no marketplace to trade syndications to determine value, unlike Real Estate Investment Trusts (REITs) which are marketable securities and often confused with direct investments in real estate syndications. Alternatively, stock values are determined by a marketplace. As such, the value is not just driven by the fundamentals but also by other market factors like investor sentiment and technicals. And thus the big tradeoff is that while you do have a more definitive way to drive value increases for real estate syndications, your money is tied up over the course of the investment as there is not a market of exchange.
  • Real estate syndications provide diversification of profits, whereas the typical retirement investor is only looking for max appreciation that reaches at least 7% annually.. There are 3 ways investors profit with real estate syndications:

• Annual cashflow of 5% or more over a typical 5-6 year hold period, typically paid quarterly

• Doubling of the investment over the hold period (includes the annual cashflow), i.e., a 16%-20% average annual return

• Tax savings from depreciation write-offs that can offset some or all of any capital gains taxes due at sale

  • There is direct investment in a physical asset where you can have personal contact/relationship with the operators of the investment. Several of my mentors have taught me that education reduces risk, and reduced risk eliminates the need for broad diversification. In fact, most successful entrepreneurs/investors got there by concentrating their focus, not diffusing it. Many just invest in one segment, like multifamily or self-storage or mobile home communities. Others choose to invest in multiple segments, but it’s not a prerequisite to success. The key is getting educated, and getting informed about the opportunity and the operator, regardless of the real estate segment. More on this below in the full list of next steps.

Diversification Tips for the Passive Real Estate Investor

Here are some of the best practice tips to figure out your diversification approach as a real estate syndication investor.

  • Get clear on your goals and make sure your investments match. If your retirement calls for 12% growth in your portfolio but you are only achieving 6%, your savings amount is maxed, and you are working as many hours as you can in jobs you love, the only option is to increase your return. That can be done via learning how to invest in individual stocks or options or futures, investing more in strong real estate syndications projecting 15%+ returns, or investing in other opportunities that exist (buying businesses, investment clubs, and more).
  • Get educated on how to invest in these higher-return assets/opportunities. If you decide to pursue real estate syndications, learn about multifamily, self-storage, mobile home communities, hotels, and more. As stated earlier, the more you understand the less risky an investment becomes. Then, your allocation can be driven by your own allocation rules instead of being limited by a fear that will keep you from your goals.
  • Investing in anything is risky, so risk management rules are always necessary. For your real estate syndication investments, determine what’s comfortable to you…you want to be okay financially if the investment went to $0. For me, 5% of my net worth is the most I will invest in any one asset.
  • Most of my real estate syndication investments are in multifamily (considered over-concentration based on Wall Street allocation rules). But there is a role for diversification in that I look to invest in different markets so that issues in a particular market does not impact all of my properties. Diversification is a key tool but must be used wisely and appropriately.

Make Diversification Your Tailwind, Not Your Headwind

Having taken a look at Wall Street based diversification methodology, reflect for a few minutes on whether you need to rethink how to apply diversification to your current and future real estate syndication investments. Have you limited your investments because you are trying to diversify based on the Wall Street thinking of allocating a low amount to what might be considered a riskier asset? Or have you invested more aggressively and more appropriately because you realize that education and due diligence around a specific opportunity greatly reduces the perceived risk and may propel you to your goals faster?

Imagine having a portfolio that’s better matched to your growth goals, where instead of having a 60/40 stock/bond portfolio earning 7%, you have a 30/20/50 stock/bond/real estate syndication portfolio that is projected to generate a 13% average annual return that meets your growth goals. Having provided this educational point, remember I am not a financial advisor and this is not a recommendation…you will need to consult with specific financial professionals for advice.

But as you seek continued educational guidance and support, we are here to help, to provide perspective on sound practices that have been used to grow wealth faster leveraging real estate syndications.

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