The basis of financial planning is to develop a well-diversified investment strategy that will help you to achieve your specific goals and objectives. The problem is that, if you truly do not understand what "diversification" means and what tools are available to you, you are setting yourself up for failure. The average investor has been misled into thinking that diversification is about owning different types of domestic stocks (large, medium, and small companies) and focusing on different management styles (growth vs. value). This is not diversification. Diversification involves owning different "asset classes." Asset classes are defined as various categories of investments that are affected differently as economic conditions change. They do not go up or down for the same reasons and are distinctly different from one another. I would define the major asset classes to include: cash, domestic bonds, domestic stocks, international bonds, international stocks, real estate and commodities. In order to achieve true diversification, these asset classes must be utilized.

Investing has changed tremendously over the years. We have seen a transition away from defined benefit pension plan into defined contribution plans, including the 401K. In the past, the management of defined benefit pension plans was handled by the professionals. A company was instructed to put aside a certain amount of money in order to be able to pay employees a pension when they retired. Institutional money management firms managed the money utilizing asset allocation models based on modern portfolio theory. They did not have to answer questions about why their portfolios were not keeping up with the Dow Jones Industrial Average; nor did they have to defend their investment philosophies against comments made by a journalist on CNBC. They did their jobs and accomplished their goals.

Today, investing is much different. It is left to the individual, either through a retirement plan, in which they control the investment decisions, or in personal accounts. Institutional money managers are well educated about investing. Individuals are not. Typically, individuals do not have the time or expertise to research all the investment options available and study modern portfolio theory, which is the basis of asset allocation. Therefore, they watch CNBC, read Money magazine and buy books by Suze Orman. The portfolios created via these sources are mainstream – created by the desire to sell more advertising and books – not to provide personalized investment advice.

The media does not spend too much time on real estate investing simply because it is difficult to create hype surrounding an asset class that can so easily be evaluated. Hype can be easily created around investment categories that arouse emotion and are more difficult to understand, like the stock market. The result of this lack of attention is that the individual investors do not become educated about them, unless they take the initiative on their own. Psychologically, I think they also feel that if the media does not cover it, then it is not worthy. This could not be farther from the truth.

There are many ways to own real estate and incorporate it into a portfolio. Although a primary residence is considered to be real estate, we typically do not like to include it as part of the overall asset mix for investment purposes. Most people do not use their house as an investment. They use it as a place to live. It is their security. An investment is something you benefit from, either via an income stream or capital gain. Most people do not sell their house just because it goes up in value. If they do, more often than not, they reinvest the proceeds into another residence. The only time we would consider including the residence in the asset allocation mix is if there are plans to sell the house in the future and convert the proceeds into another investment – not a primary residence. This sometimes is the case if two homes are owned and downsizing will take place in the future.

However, aside from a primary residence, outright ownership of investment real estate is the most direct method of diversifying wealth. From a financial perspective, outright ownership is the most simplistic. A person can easily gain an understanding of the numbers, which would include debt services, expenses, income generated, appreciation potential, etc. The potential risks involved can also be more easily identified. The downside is that more time is required. The maintenance and management of the property will fall on the owner’s shoulders. If a person decides to hire a third party to take care of these issues, he/she should be sure to include the costs in his/her expenses. People often ask the question of why someone would want to sell a piece of real estate if it is such a good investment. Many times, individuals sell real estate because they do not want to deal with the management of the property, or the property may have appreciated and they want to capture their gains and lower their overall exposure to real estate.

Another way of owning real estate is through a Real Estate Investment Trust (REIT). Congress created REITs in 1960 to make investments in large-scale, income-producing real estate accessible to smaller investors. A REIT is an operating company which owns and manages commercial real estate. They are chartered as a corporation or business trust. They provide investors with the pass-through of income. In addition, depending on the type of REIT own, there may be tax advantages.

The owner of a REIT earns a proportionate share of benefits generated by the investments. REITs can be publicly traded or private. Public REITs are listed on the stock exchange. This provides the investor with the ability to buy and sell at any time. A private REIT does not offer the same liquidity. Private REITs are sold through financial advisors and may require the investors to hold the REIT until management decides to either list it on a stock exchange or liquidate the properties and return the pro-rata proceeds to the shareholder. Although publicly traded REITs provide liquidity, they also are subject to stock market fluctuation. Therefore, the value of the investment is not solely based upon the underlying real estate and management. Many investors have gravitated toward private REITs over the last few years in order to avoid stock market fluctuations.

The main advantage of REITs is that they are equity investments that can produce generous cash flow, along with the potential capital appreciation. The average REIT yields approximately seven percent – not bad considering our low interest rate environment.

When analyzing a REIT, you want to be sure that you understand what types of properties the trust owns and the intention of management. One will want to know how they finance the properties (i.e. how leveraged are they?). If interest rates increase, what impact will that have on the debt costs? Where are they investing, geographically? What are their plans with the trust? If it is a private REIT, do they plan on selling the properties or listing on an exchange?

An investor may be asking, "Why should I go through all of this? It sounds like a lot of work." There is another alternative. Some mutual fund companies offer funds that invest in REITs. That does not mean that you do not have to do your homework. You still need to research the fund to gain an understanding of the fund manager’s philosophy.

Understanding real estate investing and diversifying your portfolio accordingly can have a huge impact on your overall investment success. Remember, diversification is about investing in assets classes that do not respond the same as economic conditions change. Consider the returns in the stock market from 2000 to 2003, compared to the NAREIT index (benchmark for REITs): 2000 – S&P (-22.08 percent) vs. NAREIT (+26.36 percent); 2001 – S&P (-12.73) vs. NAREIT (+13.93 percent); 2002 – S&P (-23.59) vs. NAREIT (+3.80). In 2003, the stock market started to recover with S&P performance of +25.66 percent. This would lead you to believe that the NAREIT index must have slowed down. It did not. As a matter of fact the NAREIT index was up +37.10 percent. This comparison is an example of different asset classes. If an investor properly diversifies his/her money, he/she can have the potential of increasing overall portfolio returns while reducing risk.

When we consider a few different assets classes to examine the long-term viability of the sector, the results are positive. During the time from 1973 to 2003, US Bonds returned +9.40 percent; S&P 500 was up 12.19 percent; Equity REITs outperformed the S&P with positive performance of +14.18 percent.

Most individuals consider themselves to be long-term investors as opposed to market timers. The only way to truly be successful over the long term is to have exposure to asset classes which compliment each other through non-correlation. One of the challenges to this approach is that a person must recognize that it is not mainstream investing. It takes some knowledge and discipline to make solid investment decisions in order to create a long-term strategy that he/she can stick with during the good times and the bad.