How Much is Too Much in a Single Investment?

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A reader writes:

“…what would you consider a safe percentage of one’s portfolio in brick and mortar real estate investments? Currently, approximately one third of my portfolio is in rental properties. I have pulled back on investing in the stock market for now and am considering increasing my percentages in the rental market versus other potential investment strategies. I have a good salary, a good profession, am 52 years old, and not yet ready to consider retirement.”

This is an interesting question and not one that you’ll find an easy answer to from the usual financial sources. There probably is no definite answer, without modeling all the details of an individual situation, if then. But there is a lot that can be said on the larger topic of what is adequate diversification.…

Let’s start with single-company holdings. We’ve all read the sad stories of employees who had the bulk of their retirement savings invested in the stock of a single company that went bankrupt. (Just Google “Enron” or “WorldCom” if you need a reminder.)

A 2008 study by the Employee Benefit Research Institute reported that almost one-third of workers in their sixties who were eligible to own company stock in their 401(k) plans, had more than 20% of their account in company stock. Is that too much? How about the 8% who reportedly had more than 90% of their retirement holdings in company stock?

According to FINRA (the Financial Industry Regulatory Authority), “The general consensus among financial experts is that an adequately diversified portfolio should have no more than 10 to 20 percent of total investment assets in company stock.”

My own comfort level, based on real world experience, not a mathematical analysis, is also around the 20% level for any undiversified holding. And even for diversified holdings, like say a balanced mutual fund from the irreproachable Vanguard, I’ve hesitated to go much over 30% in any one holding.

When it comes to real estate, let’s start by asking how much real estate the average investor might own through a typical investment portfolio. The Lazy Portfolio page on the Bogleheads forum shows various experts recommending from 5% to 20% in real estate or REIT’s (Real Estate Investment Trusts). For what it’s worth, I’ve typically held about 15%.

Do these percentages apply to other forms of real estate too? Think about the nature of real estate you own and manage for income. As I wrote in 3 Proven Investment Strategies, I do believe that rental real estate is one of the few proven ways for ordinary people to build wealth. I’ve seen enough personal success stories to know it works. (It just wasn’t my path, because a primary requirement is that you enjoy, or at least tolerate, working on houses and managing tenants.)

Rental real estate is part investment and part business. You must be prepared to run a small business, or find a cheap and trustworthy manager who can do it for you. (Extremely difficult, from what I hear.) As a small business owner, you would be in good company to concentrate a high proportion of your wealth in your business. It’s not uncommon for a small business owner to have most of his or her net worth wrapped up in the business — certainly more than 20%-30%. But does that mean you should put all, or most, of your investment eggs in the real estate basket, if you have a choice?

One way to answer that question is to look at the historical standard deviation in returns and ask yourself whether you can live with the volatility. We know from recent experience that stock markets can lose 50% of their value in a relatively short time frame. If you own a substantial percent of stocks, you have to ask yourself whether you can live with having their value cut in half for a few years, maybe longer. (Most of us don’t have to speculate on this question: we can simply review our portfolios, and our reactions, over the past few years!)

The same analysis can be applied to real estate. The S&P/Case-Shiller Home Price Index, a prominent measure for the U.S. residential housing market, fell more than 30% from its peak around 2006. Will you sleep OK with your assets shaved by one-third? Keep in mind that the declines have been more severe in certain parts of the country. Also keep in mind that real estate is famously illiquid: you’ll have a hard time getting your money out in a hurry. So safe real estate investing presumes either, cash-flow positive deals, or operating cash from other sources.

What about the possibility of a total loss? That’s virtually impossible with any mainstream mutual fund or ETF — because there is a measure of inherent diversification in holding multiple companies. But a total loss is not unthinkable for directly-held investment real estate, if it’s concentrated geographically or under a single manager (even yourself), for example.

Would a total loss of your real estate or other concentrated investment devastate your lifestyle, or do you have enough other assets? And is that potential risk worth the investment return? Many people, myself included, might answer: “I don’t think I’ll take that chance,” above the 30% mark, and would diversify. Others would answer “I trust real estate (or CDs, or government bonds, or gold, or something else) more than the stock market,” and they would rather concentrate.

My bottom line: if I were to concentrate in a single type of investment, it would need a few key qualities:

  • It would have to offer inflation protection, because that is a near-certain risk going forward
  • It would have to produce income, so I could live off it and never be forced to sell it in a down market
  • It would have to be diversified against geographic and management risk
  • It would have to be something I was interested in, and knowledgeable about it, so I’d have an edge in assessing the risk

By these measures, rental real estate, especially if not too concentrated in one area or under one manager, might pass muster. But only you can truly make that judgment about your own desired level of risk with your hard-earned money.

So, how much is too much of a good thing? Do you have any relevant experiences or rules of thumb? Please post a comment below.

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