Diversification is used to reduce an investor’s exposure to the

risk of a particular asset class or security. By diversifying, an

investor is less likely to suffer a major loss compared to what the
risk would be if the portfolio was concentrated in a single asset
or security. Diversification is a technical topic but here are two
basic concepts that every investor should be aware of: asset
allocation and security selection.

WHAT IS ASSET ALLOCATION?

Asset allocation is determined once an investor figures out his or

her risk-return profile, along with their objectives and unique
circumstances and constraints in the investment policy
statement. The allocation outlines what type of assets and in
what proportions the portfolio should be invested in. This step
comes before security selection; before you pick your individual
investments.

For example, an investor who has a short-term time horizon and

is close to retirement should consider allocating his or her
money in asset classes that have low-volatility and fixed returns.
In this case, the investor should choose mostly fixed income and
money market securities as the main asset classes of choice.
Notice how we didn’t specify which securities they should
consider but rather only the type of asset. Choosing the actual
stock or bond or other investment holding is part of security
selection.

Before we go further, let’s briefly describe what an asset class

is. An asset class is a term that describes a group of investments
that behave in a similar manner during market or economic
events. These include equity (stocks), fixed income (bonds),
commodities, real estate, preferred stocks, and other alternative
assets. These are all different types of assets. An individual asset
class can be thought of as a family of investments, much like
your family, you have similar genes, DNA, and possibly share
the same traits and characteristics.

DIVERSIFYING ACROSS MULTIPLE ASSET CLASSES

Asset allocation involves diversifying your portfolio across

multiple asset classes. The reason this is important is because
different asset classes have varying risk-return profiles, they
have a low correlation to one another, and holding multiple
types of assets provides a more favorable return for a given level
of risk (i.e. it improves the overall portfolio sharpe ratio).
For example, suppose you have a portfolio with an asset mix of:

 60% equity
 30% fixed income
 and 10% real estate

Portfolio Asset Allocation Chart Example

What this means is that 60% of your portfolio is invested in the

equity asset class (stocks), 30% in fixed income (bonds), and
10% in real estate. Now, suppose there is a big market crash or
correction. In this case, generally, most stock prices go down,
while bond prices rise. That’s due to investor fear and flight to
safety. Because bonds and stocks have low correlation or even
negative correlation in some cases, your portfolio losses are not
as bad as they would have been had all your holdings been in
stocks at the time of the crash.

Asset allocation accounts for most of the portfolio returns. In

other words, it matters less which exact holdings you have in
your portfolio. What matters more is the type of assets your
portfolio is comprised of. For example, if all your holdings are
100% equity, the fact that they’re equity matters more than
whether you invest in the SPDR S&P 500 Index
(SPY) or iShares Core S&P Mid-Cap ETF (IJH).

SECURITY SELECTION

Once a portfolio’s asset allocation is determined, an investor

needs to select securities or pick the actual individual portfolio
holdings. Let’s go back to our previous portfolio example:

 60% equity (stocks)

 30% fixed income (bonds)
  10% real estate

In this case, an investor needs to pick securities for each asset

class. So 60% of the portfolio needs to be allocated to picking
stocks or securities that invest in stocks. This could include
mutual funds or exchange-traded funds that hold a portfolio of
stocks. The benefits of these fund investment vehicles is that
they provide instant diversification through just one or a few
funds.
To make up that 60% of your portfolio, you can also be stock
picking. When considering what stocks to buy, it would be wise
to look at fundamental and technical factors. How to pick the
best stocks is beyond the scope of this article but we’ll discuss it
in upcoming topics.

Same goes for your other assets, you’ll need to pick funds or
individual bonds to make up 30% of your portfolio. While the
last 10% can be invested in REITs, actual real estate properties,
land or other real estate investments. Read about the 6 common
ways of investing in real estate here.
CONCLUSION

Just to recap, asset allocation determines what type of assets

your portfolio should be made up of and in what proportions.
Whereas, security selection is the process of actually picking the
individual holdings in your portfolio that make up the asset
allocation in the right proportions. Both of these are important in
the portfolio creation process. However, generally speaking
asset allocation has a bigger impact on portfolio returns than
security selection.
Six Types of investments in Real State

Real estate is one of the best asset classes to invest in. Financial
advisors and portfolio managers won’t tell you this because they
don’t earn percentage fees when you invest in real estate unless
you are buying a real estate investment trust (REIT) fund or
ETF. Obviously, if you speak to mortgage brokers and real
estate agents they would tell you that buying properties is the
way to go. Of course, they are biased as well since they earn
commission fees when you buy homes.

Here’s an unbiased opinion – real estate investing is an amazing

way to get ahead in your investment journey. Take it from
someone who doesn’t earn money by telling you this and has a
lot of experience in the real estate market. If done right, real
estate investing could bring you a return on investment (ROI)
higher than stocks, bonds, commodities, and other asset classes.

Below are some ways you, as a retail investor, could invest in

real estate.

1. PHYSICAL RESIDENTIAL REAL ESTATE RENTAL

PROPERTIES
This is my preferred way of investing in real estate. All you
need to do with this method is to check out houses for sale, do
some investment calculations with a proper real estate model,
and buy a property that makes financial sense. This method will
be the focus of this article in the next section. Let’s look at some
advantages and disadvantages of this type of real estate exposure
in your investing portfolio.
Advantages of Investing in Residential Real Estate Rental
Properties:

 Potential for positive cash flow every month.

 Significant return on equity (ROE) through a lot of
leverage through a mortgage from the bank. Your net worth
is likely to increase faster than most investors realize.
 You have full control over the asset.
 You can see the asset with your own eyes and it’s real and
physical. It’s not just a number on a screen.
 Paydown of the mortgage over time, which further
increases return.
 You can combine this method with real estate flipping –
which is the process of buying an old house that needs
renovations and reselling it.
Disadvantages of Investing in Residential Real Estate
Rental Properties:

 Need a lot of capital to get started with buying a property.

 Might be hard to obtain a mortgage from the bank if you
don’t have capital, have poor credit, or don’t earn a lot of
money.
 Things in the house might break that you’re responsible for
fixing, which could mean unexpected expenses.
 Have the potential to lose more than your initial capital
during a big real estate market correction. A good example
where this was the case for many real estate investors is the
2007-2008 real estate bubble and subsequent meltdown.
  Vacancy risk – if your property is vacant it’s not generating
any cash flow. You might have a hard time finding tenants
in certain geographical regions and locations.
 Tenant related issues – this could include missing rent
payments, ruining appliances, walls, floors or other things
in the home. They may also move out suddenly without
telling you even if it’s against their agreement.
 Liquidity to transact with physical real estate is poor. This
basically means that it takes a while to buy or sell real
estate. It could take weeks or even months to buy or sell a
house.
 Real estate transactions can be costly when buying and
selling homes. This includes land transfer taxes, lawyer
fees, an inspection, real estate agent costs, sometimes
appraisal costs and other fees.

2. YOUR HOME
The house or condo you live in or planning to buy at some point
in the future is also a real estate investment. Just like buying a
physical residential real estate property, you need to physically
search for houses, figure out what makes financial sense and buy
the right home for you.

Advantages of Owning Your Own Home:

 Everyone needs a place to call home. Might as well own

the asset in which live.
 You won’t be “throwing away” rent money out of the
window. Though there are other aspects to consider on this
rent vs. purchasing real estate decision.
  No tenant associated risks since you’re the one that lives at
the property.
 You have full control over the investment.
 Similarly to the rental property we mentioned above, you
can see the asset with your own eyes and it’s real and
physical. It’s not just a number on a screen.
 You could rent out parts of the home you live in and
generate some cash flow. For example, if you rent a room
or the basement of the house, that could generate some
extra cash.
Disadvantages of Owning Your Own Home:

 In some cases it may make sense to rent instead. We’ll

explore renting vs. buying a home in another article.
 You usually need a lot of capital for the initial down
payment on a house.
 Interest expenses on the mortgage could be hefty.
 You will not have a positive cash flow from this type of
investment.
 Again, similar to the first way of investing in real estate, it
may be hard to obtain a mortgage if you don’t have capital,
have poor credit, or don’t earn a lot of money.
 If something breaks in your house, you pay to get it fixed.
You can’t call your landlord every time the furnace or
washing machine gives you trouble; you, as the owner,
have to deal with any necessary repairs.

3. VACANT LAND
“They don’t make any more land” as the famous quote goes.
And it’s true. A lot of the time, the land real estate where a
house sits is more valuable than the structure itself. You would
need to look for land for sale in a decent location where the land

will become more valuable over time. It should be an area where

people are migrating to and that’s becoming more popular over
time. You could either wait for the land itself to increase in
value and then sell it or build a house on the land you purchase.

Advantages of Investing in Vacant Land:

 Land is scarce since you physically cannot create more of

it.
 Generally, you have the freedom to create what you want
on that land. Could be used for many different purposes
that could generate maximum value, assuming zoning laws
are being followed.
 Usually, you have direct ownership of the land without
debt. Therefore, there’s no anxiety related to any kind of
mortgage payments.
 Don’t need to worry about maintenance the way you would
for a rental property.
 It’s cheaper than developed land.
Disadvantages of Buying Land:

 No immediate cash flow potential.

 Still encounter property tax, which contributes to negative
cash flow.
 May require a lot of capital, depending on the area where
you buy the land.
  To build anything on the land will also generally cost a lot.
 Not many banks or institutions are willing to lend money to
purchase and build on land, unless you’re in the business of
building real estate properties.
 Since there’s no mortgage on the land, you won’t be able to
have mortgage interest tax deductions.
 Permits, zoning, and legal approvals are some concerns
you’ll need to consider. How many lots, what type of
properties and other restrictions will apply when
developing on land.

4. REAL ESTATE INVESTMENT TRUSTS (REITS)

REITs are securities that own, manage and usually rent out all
kinds of real estate. Some REITs focus on residential housing,
others on commercial and industrial properties. Public REITs
are like stocks that you can be purchased on stock market
exchanges. Some large ones on the Toronto Stock Exchange
(abbreviated TSE or TSX) include H&R Real Estate Investment
Trust (HR-UN) and Riocan Real Estate Investment Trust (REI-
UN). In the US, some big names include American Tower Corp
(AMT) and Simon Property Group Inc (SPG). This is not the
best way to grow your net worth through real estate, but let’s
look at some advantages and disadvantages of investing in this
investment vehicle.

Advantages of Investing in REITs:

 You don’t need a lot of money to get started with this kind
of investing.
 The only amount you could lose is your initial investment.
  Liquidity – you can buy and sell these investments within
seconds. Whereas, actual real estate properties could take
weeks or months to sell or buy.
 As an investor, you receive regular monthly or quarterly
dividends from these investments, since REITs are required
to pay out at least 90% of their earnings to investors. The
dividend yields on REITs are very attractive and can range
from about 3% to over 10%.
Disadvantages of Investing in REITs:

 You can’t utilize the massive leverage advantages of

getting a large loan (mortgage) from the bank when buying
a house or property.
 REIT prices fluctuate on a daily basis. Therefore, your
investment is subject to a lot of volatility.
 There is a security specific risk if you don’t diversify and
only buy one REIT security. An example of this risk
includes the bankruptcy of a specific REIT you invested in
or even just a lawsuit that the company lost, which may
cause the price of the shares to crash.
 Every time you buy or sell REITs, you’re subject to trading
costs.

5. EXCHANGE TRADED FUNDS (ETFS) WITH REAL

ESTATE EXPOSURE THROUGH REITS
An Exchange Traded Fund (ETF) is a basket of securities that is
wrapped in a fund. This investment vehicle trades on a stock
exchange similarly to stocks. REIT ETFs are just real estate
funds that hold a basket of REIT securities. Some of the bigger
once on the Toronto Stock Exchange (abbreviated TSE or TSX)
are BMO Equal Weight REITs ETF (ZRE) and iShares
S&P/TSX Capped REIT Index ETF (XRE). In the US, some big
names include Vanguard Real Estate Index Fund (VNQ) and
Schwab US REIT ETF (SCHH).

Advantages of Investing in REIT ETFs:

 Instant diversification of a basket of REITs through ETFs

that hold them.
 Low transaction costs when buying and selling ETFs.
 Most ETFs are very liquid and it can be easy to buy and
sell these funds throughout the business day.
 This type of fund has a relatively low annual expense ratio
or fee than most other types of funds, such as mutual funds
and hedge funds.
 ETFs are very transparent with their underlying holdings
since they are required to report their holdings on a daily
basis.
 You can short sell ETFs, the same way as stocks.
 You can buy ETFs on margin, just like stocks.
Disadvantages of Investing in REIT ETFs:

 Similar to individual REITs, ETF prices fluctuate on a daily

basis. Therefore, your investment is subject to a lot of
volatility.
 Every time you buy or sell ETFs, you’re subject to trading
costs.
 ETFs may experience tracking error, which is return
deviation from the index passive ETFs are meant to track.
 This means that the ETF may not track the performance of
the underlying index properly.

6. MUTUAL FUNDS WITH REAL ESTATE EXPOSURE

Just like an ETF, a mutual fund is a basket of securities that is
wrapped in a fund. However, mutual funds do not trade on stock
exchanges and can only be bought and sold at their net asset
value (NAV) after markets close (4 PM EST on NYSE for
example). The fee structure and taxation is also different
between ETFs and mutual funds. Real estate mutual funds are
mutual funds that hold a basket of securities related to real
estate. These could include REITs, home builders, and other real
estate companies. Some of the more popular ones are Vanguard
Real Estate Index Investor (VGSIX) and DFA Real Estate
Securities I (DFREX).

Advantages of Investing in Mutual Funds with Real Estate

Exposure:

 Same as ETFs, there’s the benefit of instant diversification

of a basket of real estate securities and REITs in a real
estate mutual fund.
 Unlike ETFs, mutual funds allow the investor to reinvest
their dividends into the underlying mutual fund
automatically without incurring transaction fees.
Disadvantages of Investing in Mutual Funds with Real
Estate Exposure:

 Usually have higher fees than other funds, such as ETFs.

  Mutual Funds are less transparent than ETFs since mutual
funds are only required to report their holdings on a
quarterly basis.
 Mutual fund prices or net asset values (NAVs) change at
the end of every day. Therefore, your investment is subject
to a lot of volatility.
 You can only buy or sell mutual funds at the end of the day.
Unlike ETFs that trade throughout the day.
 You cannot short sell mutual funds.
 A lot of the time mutual funds have investment minimums
that are not accessible to all investors.

THE BOTTOM LINE

All of these methods of investing in real estate are subject to
market forces as well. These can be advantages or disadvantages
depending on which way the market is headed; any real estate
investment has the potential to increase or decrease in value over
time.

This is not an all-inclusive list of ways of investing in real estate

but is meant to highlight some of the most popular ones. Other
methods of real estate investing may include commercial real
estate investing, industrial buildings, house flipping, rent-to-
own, cottages, temporary renting through Airbnb, investing in
home construction companies, and many more. For the purposes
of this article, I wanted to keep it relatively simple.