The Importance of Diversification Outside of the Stock Market
Investors often think of the stock market as the go-to investment option. However, there are several reasons why it is critical for investors to construct a diversified portfolio - well beyond the stock market, alone. With the current economic climate marked by the pandemic and historic interest rate hikes - the recession resiliency of an investor’s portfolio is more important than ever. Additionally, inflation is on the rise, and traditional investments (i.e. stocks) may not serve as an adequate hedge against high inflation.
In this article, we will explore what we mean by the term “diversification,” the importance of it and some alternative investment avenues that can offer recession resiliency and protection against inflation.
What Do We Mean By “Diversification?”
Traditionally, investors believed that diversification simply meant spreading their capital within the stock market across different asset types, companies and industries. As we have learned many times over the course of history - most recently the Great Recession - investing solely in one type of investment can land you right into bankruptcy. True “diversification” means spreading capital outside of the stock market, across multiple asset classes - some of which are non-correlated to the traditional assets - increasing the likelihood of achieving long-term investment goals. This strategy offers investors a way to spread their risk and reduce the impact of market fluctuations on their overall portfolio.
Why is Diversification Important?
Diversification is crucial because it can provide investors with recession resiliency. During a recession, traditional investments like stocks can lose significant value, but having a diverse range of assets can help mitigate losses. Moreover, diversification can provide protection against inflation. Inflation is the rate at which the general price level of goods and services is increasing. As inflation rises, the value of cash decreases. Traditional investments like stocks may not offer an adequate hedge against inflation because values are more correlated to market performance than inflation rates. However, alternative investments like real estate, precious metals, and contemporary art, amongst other asset classes, offer downside protection from inflation.
What are Some Alternative Investment Opportunities?
Let’s explore what non-correlated assets are. Non-correlated assets are investments that tend to move independently of one another, meaning they are not affected by the same market conditions or economic factors. Some examples of non-correlated assets are precious metals, contemporary art, collectibles, and digital assets. Diversifying your portfolio with non-correlated assets helps to minimize risk and volatility, as losses in one asset class may be offset by gains in another. On the other hand, investing in different industries within the stock market may still leave your portfolio vulnerable to market conditions and economic factors that affect those industries as a whole.
Commercial Real Estate
Commercial real estate investment is an attractive alternative to stock market investment because it offers recession resiliency and inflation protection. Some examples of commercial real estate investment approaches are real estate syndications and real estate funds in asset classes such as multi-family properties, self-storage facilities, industrial properties and more. Multi-family properties are apartment complexes, while self-storage facilities are buildings that offer storage space for rent. Industrial properties are buildings used for manufacturing or storage. All of these commercial real estate investment routes have the potential to offer steady cash flow and appreciation potential while also offering tax benefits through tactics such as depreciation and passive losses.
Precious metals like gold, silver, and platinum have historically demonstrated low correlation with other asset classes, providing an additional layer of diversification and reducing overall portfolio risk. Additionally, their ability to retain value during economic downturns can act as a hedge against inflation and market volatility.
Investing in art can be beneficial when diversifying a portfolio outside of the stock market because it can offer a potential long-term return on investment. Art, like a fine wine, tends to get more valuable as time passes. Additionally, art is a tangible asset with very little correlation to the stock market, much like precious metals. Lastly, according to the Citi Global Art Market chart, as of December 2020, contemporary art has offered an annual return of 14% over the last 25 years, versus a 9.5% annual return from the S&P 500.
A collectible can be defined as an item when it is purchased with the expectation that its value will appreciate over time, and it is held with the intention of selling it at a higher price in the future than its original purchase price. Examples are rare stamps, coins, antiques and sports memorabilia. These tangible assets have the potential for high returns in the long term and can work as a hedge against inflation.
Cryptocurrencies and NFTs are an emerging alternative investment avenue. Cryptocurrencies like Bitcoin and Ethereum have gained popularity in recent years as a hedge against inflation and market volatility. Some believe that while volatile in the short term, they have the potential for significant appreciation over the long term.
Is it possible to diversify within the stock market?
Traditionally, investors believed that investing in the stock market across many different asset types and industries was how one would achieve diversification within a portfolio. True diversification means spreading capital outside of the stock market and across non-correlated assets such as commercial real estate, commodities such as precious metals, collectibles and digital assets increasing the likelihood of achieving long-term investment goals.
Are alternative investments riskier than traditional investments?
Alternative investments can be riskier than traditional investments because they tend to be less liquid and some have a less established track record. However, some investors believe that alternative assets can offer unique benefits such as recession resiliency, hedging against inflation, and in some cases potential tax benefits. Whether the risk is equal to the reward should be determined by the investor based on what their risk tolerance is.
How much of my portfolio should I allocate to alternative investments?
The amount you allocate to alternative investments depends on your risk tolerance and investment goals.
There is no one-size-fits-all answer to how much of your portfolio should be allocated to alternative investments and we highly recommend you consult with a financial professional to determine what kind of investment strategy best suits your long-term financial goals. We believe that alternative investments should not be the sole focus of an investment portfolio, but rather part of your portfolio’s diversification strategy.
Can I invest in commercial real estate without buying a physical property?
Yes, it is possible to invest in commercial real estate without the need to actually buy an entire property. This can be achieved through different investment vehicles, including: real estate syndications and real estate funds. A real estate syndication is an investment vehicle formed when a group of investors (Limited Partners or LPs) pool their capital together to purchase a property or a portfolio of properties. Similarly, a real estate fund is an investment vehicle that pools together capital from a group of investors and invests in a diversified portfolio of real estate assets. Both investment vehicles allow investors to passively own a piece of commercial property without the hassle of actively managing the asset because the General Partner (GP) is responsible for all the heavy-lifting. By investing in real estate syndications or real estate funds, investors can benefit from potential rental income and property appreciation without the hassle of property management.
Are digital assets a safe investment?
Digital assets like cryptocurrencies and NFTs are considered to be a high-risk investment. They can be highly volatile and are not backed by any government or central authority. However, supporters believe that while volatile in the short, these assets have the potential for significant appreciation in the long term. For investors who are willing to take on the risk, we advise you conduct thorough research and understand the risks involved before investing in digital assets.
Diversification outside of the stock market is critical for investors who want to protect their portfolios from market fluctuations and inflation. Non-correlated assets, including commercial real estate, precious metals, art, collectibles and digital assets are just a few examples of alternative investment vehicles that can offer recession resiliency and inflation risk mitigation. It's important to remember that alternative investments should be a complement to a well-diversified portfolio and not the sole focus. Investors should conduct thorough research and seek professional advice before making any investment decisions.
Learn More About Successfully Investing in Real Estate
Real estate is among one of the most attractive investment opportunities available due to its recession resiliency and protection against inflation. But many would-be investors struggle to match their financial goals to an investment strategy.
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