2018 was a roller coaster for the stock market. If you’re an investor, you were probably impacted more than once – for better or worse. The Dow Jones Industrial Average (DJIA), Nasdaq Composite, and S&P 500 each hit new all-time highs as the stock market soared. The S&P 500 experienced its biggest rally since 2015 and the DJIA saw the biggest single-day gain of more than 1,000 points. But the year also brought several falls. In addition to its largest gain, the DJIA also experienced its largest-ever fall in February; and in December alone, it experienced six 350-point drops. Ultimately, the year ended in negative territory for each index: the DJIA finished at -5.6%, the Nasdaq -3.9%, and the S&P 500 -6.2%.
None of this is proof of a current or impending recession. It does, however, remind us that the market is volatile. Generally speaking, if the stock market rises or falls more than 1%, it’s considered a volatile market. And as one financial director has noted, the volatility of 2018 has continued into 2019: “We’ve started off 2019 with almost as many 1% moves in the broader market as we did in some prior years for the whole year.”
With volatility pervading the public markets, many investors are rightly asking: How should I be investing when the market’s behavior is so unpredictable?
Volatility is something that every investor should consider – more specifically how to reduce exposure to it through a wise investment strategy. If an investment portfolio can only perform well in a good, stable market, it isn’t serving all of its functions. A well-allocated portfolio should be able to help investors weather unpredictable or even bad markets. That’s because a well-allocated portfolio not only has the power to earn returns, it has the ability to reduce exposure to risk that causes volatility.
How are the Wealthy Weathering the Stormy Market?
No one is immune in a volatile market, but there are steps that many investors – most notably wealthy, institutional investors – are taking to reduce their exposure to volatility in the stock market. In a BlackRock study of more than 230 institutional investors (collectively holding over $7 trillion in assets), 51% planned to decrease allocation to public market equities in 2019. That figure is up from 35% in 2018 and 29% in 2017. While pulling back from the public market, many of these investors plan to increase investment in the private market. For instance, 40% of institutional investors surveyed intend to increase exposure to real estate in 2019.
Why are wealthy, institutional investors turning to the private market when the public market becomes volatile? As the BlackRock study puts it: they’re in search of uncorrelated sources of return. In other words, they’re looking for investments whose performances aren’t related to one another. That way, when returns for one investment falls, the other investment doesn’t hold the same risk of falling as well.
Many things can cause the performance of two investments to be related – including the market in which they’re traded. Therefore, volatility in one market will likely have a lesser impact on investments in the other market. By investing in the private market, investors who hold public market investments can reduce correlation within their investment portfolio.
By diversifying into real assets, private equity, and real estate in the private market, institutional investors are investing in what’s known as alternative investments. Alternative investments have been a key component of many wealthy investors’ investment strategies, because they have the power to reduce portfolio risk and volatility while maximizing return potential.
For example, you can invest in real estate through both the public market (such as through an individual public REIT, or a composite of REITs like the Vanguard Real Estate ETF) and the private market (through ownership of a rental property or through investing through an investment platform, such as Fundrise), but a private market investment offers investors greater diversification potential due to its low correlation with the performance of the stock market. The Vanguard Real Estate ETF and the FTSE Nareit index both had negative returns in 2018, just as the stock market did, at -4% and -5.95% respectively. Meanwhile, private market real estate investments on the Fundrise platform earned an average annualized total return, net of fees, of 9.11% in 2018.
The 20% Rule
While allocation amounts can vary by investor, the “20% rule” is the general rule of thumb for individual investors. The 20% rule simply says that 20% of an individual’s investment portfolio should be made up of alternatives. This investment strategy was created by the Chief Investment Officer of the Yale Endowment, David Swensen, more than a decade ago in his book Unconventional Success: A Fundamental Approach to Personal Investment.
The Yale Endowment itself is actually more heavily allocated in alternatives than most with less than half of the Endowment invested in the public market as of 2016. The Endowment consciously shifted its strategy in 1985 when it had more than 80% of its portfolio invested in the public market. Due to changing the composition of its holdings, the Endowment’s portfolio has experienced higher than expected returns and lower volatility than experienced by previous portfolio structures.
However, the 20% rule is not limited to Mr. Swensen. Blackstone has also demonstrated the impact that the 20% rule can have on a traditional investment portfolio of stocks and bonds.
As the graph above shows, an investment portfolio containing 20% alternatives instead of the traditional mixture of only public market stocks and bonds can not only increase return potential, it can simultaneously reduce portfolio risk thanks to the low correlation that alternatives have with traditional investments.
What are the next steps?
Finding investments with low or no correlation to the stock market can greatly reduce your portfolio’s overall volatility. Alternative investments have the power to provide meaningful diversification to limit volatility, while also boosting portfolio return potential in both stable and unstable markets for individual investors. With this diversification in place, whether the stock market climbs or falls – but most importantly when it falls – you’ll have crucial exposure to assets which don’t share the same risks.
For a long time, there was one major issue with all of this strategy: access to quality alternatives was restricted to the wealthy. But thanks to advancements in technology and regulations, some alternative investments are now widely available. For example, Fundrise offers instant exposure to alternatives through private real estate – an asset class with a track record of appreciation and the potential for generating regular income. A Fundrise Investment Plan gives you exposure to the private real estate market through a diversified portfolio filled with dozens of both institutional quality debt and equity real estate investments across the US.
While the future behavior of the markets is unknown, a strong diversification strategy incorporating uncorrelated asset types may be the key to building a stable portfolio capable of weathering, and succeeding in, any market.
Ben Miller is Co-Founder and CEO of Fundrise. With over 20 years of commercial real estate experience, Mr. Miller is an innovator and champion for the everyday investor, focusing on the Fundrise mission to democratize access to real estate investing. Stay up to date with the latest from Fundrise through their social channels: Facebook, Twitter and LinkedIn.
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