Real estate provides enhanced benefits for an investor when included with other assets as part of portfolio allocation. The reason behind this outsized benefit is twofold:

• first, real estate adds a diversified return stream that bolsters the average annualized return to the portfolio;

• second, and crucially, real estate reduces the variability of returns to a portfolio by adding a non-correlated asset that dampens the price swings from other asset classes and reduces the chances of a loss of value while maintaining the level of expected return.

Real estate's low correlation with stock and bond holdings is ideal for portfolio allocation.

Real estate provides enhanced benefits for an investor when included with other assets as part of portfolio allocation. The reason behind this outsized benefit is twofold: first, real estate adds a diversified return stream that bolsters the average annualized return to the portfolio; second, and crucially, real estate reduces the variability of returns to a portfolio by adding a non-correlated asset that dampens the price swings from other asset classes and reduces the chances of a loss of value while maintaining the level of expected return.

Real estate holdings are an essential diversifying component of portfolio allocation because of their low (and slightly negative) correlation with the traditional portfolio holding 60% stocks and 40% bonds. The chart below, produced by J.P. Morgan Asset Management, shows numerous “alternative” asset classes that are often discussed in the context of portfolio diversification.

As can be seen, popular options, such as private equity and direct lending, feature a fairly high correlation with a 60/40 portfolio – meaning investors cannot mitigate much of the risk of price swings by adding these assets to a portfolio. However, real estate assets, shown in light blue, have an ideal, slightly negative correlation with the 60/40 portfolio. This means that investors can expect their real estate holdings to either move completely independently of the price swings of stocks and bonds (i.e., a correlation of 0.0), or somewhat counter to the 60/40 portfolio (with a small negative correlation). This non-correlation is exactly what is needed to minimize harmful price swings.

Uncorrelated assets respond to different forces and shift in value independently of one another.

Taking a quick step back, it is helpful to think at a conceptual level as to why various asset classes increase or decrease in value and how that can create uncorrelated return streams. Below are basic examples of general economic forces that will influence the price of a stock, bond or rental property:

• A stock’s price will often shift with changing consumer spending, when the general stock market goes up or down, when economic indicators swing to the positive or negative, or based upon the market’s reaction to the firm’s quarterly earnings results.

• Bonds have historically done well when interest rates and inflation are declining, or when the stock market is falling, and investors are seeking to reduce risk.

• A rental property’s value will fluctuate based upon the strength of its location and ability to attract renters, changing interest rates, local job growth, and competition from comparable rentals and for-sale homes in the market (not necessarily national rental and home prices). In addition, a rental property will generally rise in value in an inflationary environment, in contrast to declines experienced by many other yield-based assets, such as bonds, during times of inflation.

These examples help illustrate what is meant by “uncorrelated assets.” If you own a rental property, its value may increase when a blue-chip employer comes to town, but that factor will have no bearing on the value of your stock holdings. These uncorrelated price shifts help investors avoid the risk of losing money when the movement of one single economic factor can impact all holdings in a portfolio.

Adding noncorrelated assets increases risk-adjusted returns without any sacrifice.

The risk-adjusted returns of a portfolio can be improved with the inclusion of assets that have minimal or no correlation with each other. By “risk-adjusted returns,” this means the expected return to the portfolio relative to the projected volatility in pricing and risk of loss in any given period. The additional allure of this practice is that special or unique assets are not required. Adding investments with the same expected returns and same standard deviation can increase risk-adjusted returns if they offer low correlations and are made a part of portfolio allocation.

The concept behind this transformative wealth management practice is as follows: by adding uncorrelated assets to a portfolio, we expect that the new, uncorrelated assets will not decline (or increase) in value at the same time as the current portfolio assets. This means that their inclusion will reduce overall portfolio volatility because we would expect the uncorrelated price swings to dampen or somewhat offset overall movement. However, if each asset individually has approximately the same expected return, then over time it is expected that on average they will all deliver this average return.

Taking both of these points together, with uncorrelated assets in a portfolio, it is possible to reduce the chance of loss in any given period while keeping expected returns unimpacted, thus increasing risk-adjusted returns to a portfolio. Ray Dalio, the founder of Bridgewater Associates, the largest hedge fund firm in the world, calls this the “holy grail of investing.”

A second chart below from J.P. Morgan Asset Management provides a strong visual representation of the improvement to risk-adjusted returns.5 In the chart, J.P. Morgan included an allocation of 30% alternative investments to portfolios comprised of varying levels of stocks and bonds over the period 1Q90-1Q24. In each instance, the addition of alternative assets (with a low correlation to the stock and bond portfolio) both reduced annualized volatility while either maintaining or even improving annualized returns to the portfolio:

Real estate is an essential ingredient in the "Holy Grail" of portfolio allocation.

Now that the conceptual underpinnings of a diversified portfolio of uncorrelated assets have been explored, let’s revisit the chart introduced at the top of this discussion. Note that among alternative asset possibilities, commercial real estate offers returns that come closest to featuring a zero, or minimally negative, correlation with those of a standard 60/40 stock and bond portfolio. Based on a knowledge of portfolio theory, we can see that real estate assets therefore will be most helpful in realizing the power of proper portfolio allocation.

The addition of real estate assets reduces the chance that an investor will lose money, without any sacrifice to the portfolio’s long-term performance. This is a key element in the quest for the holy grail of investing, as Ray Dalio suggested, demonstrating how real estate is an essential ingredient in all investors’ portfolio allocation.

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This article originally appeared on Capital Square's website.