The Myth of Diversification

We’ve all heard about the benefits of diversification. Don’t put all your eggs in one basket. You might have heard a family member preach about it. On the other hand, if your eggs are in one basket and guarded really well, then you will have a greater amount of control over your investments.

I had an in depth conversation with an investor this week who had made the decision to diversify his holdings across nine assets, many of them in separate geographies. All of a sudden, within a short period of time, several of them were under-performing at the same time. Diversification was supposed to protect him against that. 

I’m a big believer in diversification, but only as a secondary strategy. It’s lower priority than making sure you have a critical mass of assets under the watchful eye of a competent management team. 

Another investor I know well purchased multiples properties at the peak of the downturn. They were all bargains. But here too, they were spread across multiple markets. It wasn’t long before all five properties were performing poorly. Eventually it took hurricane Sandy to hit NYC and Atlantic City to create a success. The city was so impacted by the hurricane that suddenly her property which was undamaged, became in high demand.

By comparison, I’ve always believed in concentration of assets until you achieve optimum performance. The key item in the success of a property is not the property. It’s the management of the property. All too often I see investors focus on the physical asset. I can tell you from first hand experience that my worst investment experiences were bargains that were mismanaged. Management quality trumps asset price almost every time. If you own rental property, even if you have it professionally managed, you will need to get the attention of your property manager. The relationship you have with your property manager is a critically important relationship. I like to talk with my property managers every week, sometimes multiple times per week. But if you only have one or two units with that property manager, that frequency of communication will be burdensome for the property manager. They will look at you like you’re a nuisance. 

I believe that the ideal ratio of units to property managers is somewhere between 75:1 and 150:1. It’s somewhere in that range, depending on the type of asset. If you have 75 units with a property manager, then it’s perfectly acceptable and appropriate to speak with them once a week. You can focus your energies and your attention on that single property management relationship. 75 units starts to look like critical mass. Once you grow beyond a single multi-family property with a large number of units, you can then consider diversifying. 

If you look at much of the real wealth that has been created in the world, there has been very little diversification. The Zuckerberg family is firmly focused on Facebook. If they had divided their time and attention between Facebook, real estate, oil and gas, and restaurants, they would be nowhere close to having accomplished what they have. 

Diversification is important, but it’s a distant second in importance to having the business properly managed.