Portfolio Management with Real Estate (Part 2)
Modern Financial Planning: Portfolio Management
Many investors and financial planning firms choose to take a “top-down” approach to portfolio management. This approach begins by evaluating an investor’s lifestyle, goals, liquidity requirements, and personal considerations. Then, they determine their risk tolerance, asset allocation, and ultimately individual investment choices.
This sounds simple enough, but in practice, results may vary from person to person, particularly in adverse economic conditions. Let’s look at a few hypothetical examples, which demonstrate how the addition of real estate can help mitigate common portfolio management risks:
Sequence of Returns Risk
Perhaps the highest impact portfolio risk that retirees are exposed to is Sequence of Returns risk. This concept states that the most important long-term performance variable is not cumulative investment returns, but rather the sequence in which these returns occur. Consider the following investment results over a 30-year period:
Retiree A, who retired in 1937, would have observed cumulative stock returns of 7.4% over their retirement.
Retiree B, who retired in 1954, would have observed cumulative stock returns of only 5% over their retirement.
Retiree A’s portfolio exhibited cumulative stock returns of -9.3% in the first five years of retirement, whereas Retiree B’s portfolio exhibited cumulative stock returns of 19.5% over the first five years of retirement. Although Retiree A enjoyed better cumulative stock performance over the entire retirement period, the vastly differing performance over the early period of retirement is magnified over the remainder.
While the 4% rule does a fantastic job of mitigating the risk of complete depletion of one’s portfolio, the risk of underperformance in the early years still has a sizable impact. The historical volatility of public markets only magnifies this risk in traditional stock/bond portfolios.
Real estate investments have historically exhibited higher returns than bonds and lower volatility than stocks, which make it an attractive asset class for investors to target more return in a portfolio—without the risk of overexposure to public equities.* Investors with varying risk tolerances may incorporate CRE investments to help fine-tune their asset allocation strategy and more effectively reflect their risk tolerance, as well as their return goals. An investor might gravitate toward preferred equity investments, for example, which can offer near-term cash-flow early in retirement, placing them in a position to seize on dips in public equity values later in retirement.
Investors approaching retirement often need to manage competing goals. To realize their desired lifestyle, they may try to eliminate the risk of outliving their investments, while also maximizing their utility and spending.
By design, the 4% rule with a stock/bond portfolio does a fantastic job of addressing the former at the expense of the latter. In “bad retirement start years,” the 4% rule ensures retirees have capital at the end of retirement—granted, sometimes dangerously little—while in good times, it encourages investors to spend at levels suited for worst-case economic scenarios.
Using the 4% withdrawal rule, investors were left with more than their starting principal half the time, and more than double their starting principal 25% of the time.
https://www.fidelity.com/viewpoints/retirement/how-long-will-savings- last, August 2021
Still, investors are unable to predict returns, and are forced to spend at worst-case levels. By mitigating the worst-case scenarios using new real estate portfolio allocations, however, investors can reliably withdraw more than the 4% rule permits. Or, they can withdraw at the 4% level, with more capital remaining. Either way, diversifying across the capital stack and laddering maturities could help smooth out total capital in the portfolio through the withdrawal period.
Asset Allocation Risk
There are several ways to align portfolios with an investor’s risk tolerance, including the “bucket approach,” where investors may set aside enough cash and low-volatility investments to account for a certain period’s worth of income, putting the remainder in higher-performing assets.
No matter which portfolio management approach(es) an investor utilizes, it is important to maintain broader asset allocation through regular portfolio rebalancing, and review periodically to adjust for long-term directional changes. Deviating from an asset allocation strategy can lead to security sales at relatively lower prices and purchases at higher valuations, sinking portfolio value. In contrast, sticking to a suitable asset allocation strategy ensures that investors purchase securities at lower prices, and capture gains at higher prices.
Source: Kitces, November 2014
To put this another way, relying only on decision rules may produce a situation where the investor is never buying equities after a dip, whereas regular asset rebalancing automatically ensures that the retiree “sells high and buys low” while maintaining a consistent strategy. Note that a portfolio substantially allocated to private real estate and other illiquid alternatives will (historically) bear less cross-asset allocation and smoother aggregate returns (less volatility) over time, which should also remove risk of any “downward spiral” of mistimed equities purchases later in the drawdown period.
Source: Kitces, November 2014
The Bottom Line
Using sound portfolio management principles, investors are able to build an efficient, personalized investment portfolio. Investors can apply a similar approach in constructing a real estate portfolio. They can then diversify away from equities and bonds, potentially achieve superior risk-adjusted returns, and pursue more precisely the level of risk and return that is best suited for them.
Download the whitepaper below to learn more.
Whitepaper: Optimizing Your Retirement Portfolio through Real Estate Investing
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