You may have heard that diversification is the only “free lunch” in investing. What does that mean—and why is diversification so important?
There’s no such thing as a free lunch in investing. Be wary of risk, and you’re all but guaranteed to limit your potential returns. Take on too much risk in hopes of better returns, and you expose yourself to potential losses.
But there is one way investors can reduce risk without eliminating opportunities for return: diversification. By simultaneously investing in a diverse range of assets across different asset classes, including stocks, bonds, and alternatives such as private real estate funds, investors can offset specific or idiosyncratic risk and potentially achieve more consistent returns over the long run.
What is portfolio diversification?
Ever hear the idiom, “Don’t put all of your eggs in one basket?” That’s exactly what portfolio diversification is about.
In investing, portfolio diversification involves spreading your money (or “eggs”) across many different asset classes, industries, and geographies (or “baskets”). That way, if one investment underperforms, your other investments have the potential to offset or cushion your losses.
Asset correlation: The key to diversification
Putting your eggs in multiple baskets is a good start. But for diversification to work effectively, these baskets should be uncorrelated or non-correlated from one another. In practice, this means investing in assets whose prices fluctuate independently of each other.
Stocks, bonds, and certain alternative investments—like private real estate—have historically exhibited low correlation.1 This means that accredited investors who invest in DLP Capital-sponsored funds alongside publicly traded stocks, bonds, and other assets may benefit from a more diversified portfolio, which can potentially reduce volatility.
Why is portfolio diversification important?
Portfolio diversification is important for investors because, while investors cannot control the market, they can control how their portfolios are structured. Unlike asset allocation decisions, which involve necessary tradeoffs between risk and return, diversification is widely considered one of the few ways investors can reduce risk without necessarily sacrificing expected returns.2
Diversification reduces deal risk
When it comes to private real estate, accredited investors are often asked to choose between real estate funds and real estate syndications.
- Real Estate Syndication (One Basket): A syndication typically invests in a single deal at once.3 If that specific project encounters issues, your capital is directly exposed to that single point of failure.
- Real Estate Funds (Multiple Baskets): A real estate fund allows investors to gain exposure to multiple real estate assets across different geographies and tenant types simultaneously.
Real estate funds are comparatively more diversified than syndications because they spread exposure across many assets. Diversification does not eliminate risk or protect against loss, but it may help manage portfolio volatility over time. This structure, a signature among all DLP Capital-sponsored funds, helps reduce the impact of losses from any individual deal within the fund.
Diversification can potentially mean stable income despite market volatility
If you’re nearing retirement or are considering alternative investments, diversification can be a tool for income stability. Diversifying into income-focused investments, like the DLP Lending Fund and the DLP Preferred Credit Fund, can potentially provide you with ongoing income, allowing you to weather public market declines without needing to sell stocks or other publicly traded assets to fund your lifestyle.