If you have made any investments ever, whether it was through a company retirement account, your own financial planner, or on your own, then you have heard of diversification. Most people act like diversification is basically a guaranteed recipe for success. They brag about their diversified portfolios and how they have properties all over the country. However, in nearly all cases, diversification is not really a good thing for your returns. It’s more of a case of diworsification and will hurt you in the end.
What’s Wrong with Spreading Out My Risk?
Diversification is basically the concept that if you invest in lots of different types of things or in lots of different areas (which, for real estate, basically means completely different types of assets because the local market plays a huge role for investors), you will be less likely to lose money over the long-term. This is because usually when one type of investment is not going well, another type will be working out great. It’s a pretty simple concept, and financial planners have been advocating for it for decades because it allows them to look like financial geniuses when they simply tell you to buy a little of everything. Unfortunately, diversification is not all it’s cracked up to be.
In real estate, in particular, diversification can really create a situation where you are far worse off than you would have been if you had simply focused on a single strategy. You may have read quotes from Warren Buffett where he calls diversification “protection against ignorance” or says, “diversification makes very little sense for those who know what they’re doing”. These quotes are often confusing for investors who have been told that diversification is the smartest thing they can do.
Here is the problem with diversification and why it usually leads to diworsification:
When you spread your assets across the country, you limit the knowledge and expertise you can apply to your investment strategies.
While there may be some instances in which a real estate investor will benefit from investing in the same asset class in multiple markets, because real estate is such a relational industry, you will benefit more from diving deeply into no more than three markets and a single asset class.
It’s All About Who (and What) You Know
If we stick with Warren Buffett (who is a great source of insight as we all know), then we have to mention the “eggs in a basket” quote for which he is extremely well-known. Buffett says,
“Put all your eggs in one basket, then watch that basket very carefully.”
Think about the literal interpretation of this. There is absolutely no way to watch multiple baskets of eggs closely. You might be able to watch two or three baskets closely, but certainly not 10 or 20! And if Buffett is not good enough for you, then let’s take a look in the Bible. Think about Jesus and his 12 disciples. Do you think he had to take 12 and no more because no one else tried to sign up? Of course not! Jesus could have had hundreds of disciples if he had wanted them. But, as God’s Son in human form, He could only invest in so many people while in His earthly body for a limited time. Then, those disciples went out to spread the Word and, with one notable exception of course, they were all on-message and highly effective.
Real estate may not require the close relationship of a discipleship, but it does require close tracking of activities and a deliberate, rigorous relationship-building process over time. You simply cannot build that type of relationship or maintain that type of relationship on a grand scale. You will end up missing something important if you attempt to do so. You will diworsify instead of reaping positive, rising returns.
Find What Works and Stick With It
When you are investing in real estate, you may have a learning curve where you figure out what type of investments are right for you and what type of property managers or contractors or financial advisors are right for you. Once you figure those things out, stick with them! Refine them! You do not have to put all your capital with a new company or asset right off the bat. You can build up slowly, but only if you are not rabidly diworsifying your portfolio and trying to hedge a risk that probably wouldn’t exist if you would just take your time and focus on a smaller subset of markets, strategies, or asset classes.
Once you find the right asset class for you and the right companies to work with you as you enact your investment strategies, it’s time to home in, not spread out. Think about private lending. If you loan money to an investor for a deal and they do the deal, pay you back on time and with interest, and you have a successful, profitable transaction, you’re going to want to loan them money again. Furthermore, you are probably going to want to loan them more money! Real estate investments should be the same way. Find the right asset class, the right strategy, and the right market, then focus on finding the right people to work with as well and building up that relationship so it is as watertight and reliable as possible.
You will never regret avoiding diworsification, and you will always reap the rewards of building up stable, reliable relationships and investment portfolios. It’s simple, really. Like most good things are.