Spread your investment risk by diversifying your portfolio across different asset classes, geographic markets, time periods, fund managers and stocks.
Blogger: Hamish Wehl, funds manager, Cromwell Property Group
Diversification is the standard tactic employed to reduce the total risk of your investment portfolio. By spreading your investment risk across different asset classes, geographic markets, time periods, fund managers and stocks, losses should be isolated to independent asset classes and can ideally be offset by gains on other assets.
Why include property?
As one of the major asset classes, property is indispensable to a well-diversified portfolio. From an investor’s viewpoint, property can be split broadly into the residential, commercial, industrial and retail sectors. It can also be directly owned, like most residential property, or indirectly owned through a managed fund, a syndicate structure or a real estate investment trust (A-REIT).
All classes of property are valuable for diversification because property returns tend to move independently of other major asset classes such as shares and cash. Additionally, both residential and direct property have a low or negative correlation with other asset classes, providing excellent portfolio diversification benefits.
What type of returns does property offer?
Another consideration for your portfolio is the balance between ‘growth’ assets and ‘defensive’, or ‘income’, assets. Growth assets tend to carry greater risk, yet have the potential to deliver higher returns over longer investment time-frames.
By contrast, defensive assets tend to carry lower levels of risk and are therefore more likely to generate lower returns over the long term.
While generally classified as a growth asset, property can also provide reliable income through rental returns, along with capital growth through asset price appreciation over time. Property values fluctuate more than fixed interest and cash but not as much as shares. It is for this reason that property is regarded as a growth asset, but one at the lower end of the risk spectrum, with some defensive characteristics.
Property in different stages of life
When investors are seeking to build wealth, they tend to have an appetite for growth assets at the higher end of the risk spectrum. Younger investors in particular have a higher tolerance for short-term fluctuations in value, as they are more likely to be able to sit out the troughs inevitable in long-term investment cycles.
As investors approach retirement, their allocation to lower risk assets tends to increase, unlike that of accumulating investors. However, most retirees also require income from their portfolio. This makes property increasingly attractive in a retirement portfolio, because it generally has lower risk than equities but pays a much higher income than cash.
Direct or managed property investment?
The most common direct investment made in property in Australia is in residential. Residential property is tangible, can offer tax advantages, and is an asset that many investors understand and have experience with. However, investment portfolios that hold direct residential property can be poorly diversified due to having a large percentage of capital concentrated in one illiquid asset.
As an alternative to direct property, property investment through direct property trusts, funds and A-REITs can provide many levels of diversification and flexibility to a portfolio. While providing exposure to capital growth from property price appreciation, they are also easier to trade out of as they are unitised investments.
Greater diversification within the one asset class is also possible, as a reduced initial investment can provide exposure to multiple properties or sub-sectors such as retail, commercial, and industrial.
Property is an essential part of any well-diversified portfolio and, in addition to a balance of potential capital growth and income returns, property investment can bring diversification to a portfolio on many levels.