There can be no two more important phrases in the investors’ lexicon than diversification and asset allocation. Many folks pay lip service to diversification without really grasping its essential tenet: To achieve maximum risk reduction, you must diversify your wealth over assets with returns that are poorly or negatively correlated with each other. In other words, while having a wide range of stocks and bonds in your portfolio is a good start, these conventional assets don’t provide the diversification you need to withstand bear markets. This is an important reason why the last decade has seen increased interest in alternative investments such as real estate, precious metals, private equity, hedge funds and commodities. To a large extent, these investments offer returns that are not closely correlated with those of stocks, bonds and cash.
Once you accept the importance of real diversification, asset allocation embodies your judgements about how much of your wealth to plow into each asset class. One of the most useful notions concerning asset allocation is the “20 percent rule,” which states that investors should allocate no less than 20 percent of their portfolios to alternative investments like real estate. The rule gained notoriety from the performance of the Yale University Endowment, which has outperformed traditional endowments consisting of conventional assets for more than 25 years. In fact, Bloombergreports that a 1995 investment of $1,000 in the Yale Endowment would be worth about $13,000 in 2015, twice the return investors would have made with the average $1 billion+ endowment.
Other university endowments run by protégés of Yale Endowment investment chief David Swensen have also benefited from the 20 percent rule, including Princeton, MIT, and Bowdoin College.
Investments in real estate have their own risk/reward profiles and payback periods that markedly differ from those of conventional assets.RealtyTracreports that for the second quarter of 2016, the average return on investment for fix-and-flip home rehabbers was 49 percent, compared to a 2006 ROI figure of only 27 percent. Q2 average gross profits per flip were $62,000, and the average time required to flip a home was 185 days.
These numbers are very exciting from an investor point of view. Investors in bridge loans can expect at least a 2 percentage point premiumover the average fixed-rate mortgage, without the long time horizon required by 15- and 30-year loans. In other words, investors in short-term bridge loans receive higher returns than do investors in 15- and 30-year mortgage notes.
Once again, diversification plays an important role. The risk of bridge loans defaults can be minimized by spreading the allotted funds over many properties. To varying extents, the loans are collateralized by cash and property, which affords a cushion in cases of default. Risk is also constrained by adjusting the loan-to-value ratio on each deal, based on the value of the property and the creditworthiness of the borrower.
As the Yale Endowment example clearly shows, prudent investors should look to allocate at least 20 percent of their portfolios to investments like bridge loans in order to increase their risk-adjusted returns.