These days, there is a lot of chatter about a market correction. There are ways to deal with losses in the traditional investment portfolio. What I want to talk about today is how to use different assets for portfolio protection. When we think about tradition investing, we think about using stocks, bonds, and cash.

Real estate is a topic many personal finance bloggers, especially physician bloggers, write about. It's usually in the context of creating passive income. The right kind of real estate can be a good source of passive income. It's a reason many people choose real estate. And there are many ways to invest in real estate like REITS, private equity, and rental properties. Because it is not correlated (more on that shortly) directly with the stock market, real estate offers the potential to add the portfolio protection that many investors seek.

We're in a bull market that doesn't seem to want to quit. The problem? All bull markets end. Historically, the longer the length of the bull market, the harder the fall from it. Real estate and other types of assets offer the potential to reduce the size of the market drops when they occur.

We'll take a look at some of the options available to help you decide if they are right for you.

With that, let's get started.

Financial crisis – a reminder

In the last financial crisis in 2007-early 2009, stock markets dropped between 37% (US stocks) and over 50% (emerging markets). These are approximate numbers and meant to remind us of how markets can fall. Many investors thought they had sufficiently diversified their portfolios to cushion the market drops.

As it turns out, almost all major international stock markets dropped dramatically during the crisis. It was something that investors were not emotionally prepared to endure. It caused many to delay retirement. Some pulled out of the market entirely. Those who stayed, especially those who continued to invest, came out far ahead of the rest.

Many investors today have never experienced this type of financial crisis or market meltdown. The closest thing to it was the 4th quarter of 2018. For the most part, that all happened in the month of December. Surprisingly, it shook up many newer investors.

It's great to talk about the concept of staying invested, buying more, etc. when the market is constantly rising. It's another thing entirely to endure a significant downturn. Last year's market drop was not anything near a major decline. The further away we get from the previous financial crisis, the more sanguine we become.

I'm not a market timer nor would I ever pretend to know what the market will do next week, next month, next year or the next five years. Of this, I am quite confident, though. The market will eventually correct itself and drop. In my opinion (and it's just that) the drop will be significant.

That's why the topic of portfolio protection is top of mind for me.

Asset correlation

Those who thought they had diversified portfolios that offered reasonable portfolio protection got blindsided in the last financial crisis for one primary reason – asset correlation. When two assets are correlated, it means they move in the same direction at the same time. Negatively correlated assets move in opposite directions from each other. The degrees will vary in both positive and negative correlations. The correlation coefficient measures the degree to which these assets move together.

A correlation coefficient of 1 means the assets move in the same direction at the same time to the same degree. A coefficient of -1 means the two assets move in the opposite direction at the same time and the same amount.

Let me give you an example. If the S & P 500 goes up by 20%, another asset class, let's say, the EAFE international index would go up by 20% if they have a correlation coefficient of 1. If the EAFE had a 0.7 correlation to the S & P 500, it would go up by 14%. An asset with a correlation coefficient of -1 would drop by the same amount the other asset rose. In the prior example, the EAFE would have dropped by 20% at the same time the S & P 500 rose by that amount.

Diversification comes when various assets in a portfolio have a correlation coefficient that is less than one. Real estate is one of those assets that has a lower correlation to both U.S. and international stocks. Bonds, specifically high-quality government and Treasury bonds have an even lower correlation to stocks.

Portfolio protection

As the chart below shows, some asset classes have a low or even negative correlation with equities. Bonds, the hated asset class of many investors, provide great portfolio protection in a falling market.

What the chart clearly shows is that intermediate (5-10 years) and long term (20o+ years) Treasury securities provide the best portfolio protection in a falling market. The chart above compares the various assets to the S & P 500 for the 5, 10, and 15 year period.

The Barclay's U.S. Aggregate Bond Index is the standard used by many as the benchmark for the U.S. bond market. It has around 68% in Treasury and U.S. government or government-backed securities. The data clearly show that owning high-quality bonds was the best hedge against stock market losses in the three periods.

Treasuries as portfolio protection

Treasuries provide the best portfolio protection. Why? When fear enters the stock market, and the selling begins, investors flock into Treasuries to get the backing of the full faith and credit of the U.S. Government. In other words, the principal for these investments is guaranteed by the government. I realize that is likely a small comfort for those with distrust in how the Federal Government manages our tax dollars. Still, the U.S. dollar is the gold standard for safety in the world of investing.

It makes sense that these investments do well in a fearful and falling stock market. The higher the percentage investors had in Treasuries, the lower the losses in the last financial crisis. That's been true in virtually every major market fall.

Bonds are anathema to younger investors whose only experience is the current bull market. They argue that they have a lifetime to recover, so why hold down returns with bonds paying little to no interest. I hope they're right and can stay invested during hard times. The buy and hold investment strategy is good, until it isn't.

Most investors I know who've survived the crashes of 2000-2003 and 2007-2009 would beg to differ with my younger friends. I suspect that many will be more interested in protecting their investments after a big downturn than they are now. We shall see how this all sorts itself out when the next big hit occurs.

Real estate as portfolio protection

Real estate is an asset class that has a lower correlation to stocks. Looking at the chart above, you can see that its correlation for the five years was 0.57% and increases for the ten and fifteen year periods. The fifteen-year correlation was 0.74%. That still offers some relief, but not nearly as much as high-quality bonds and Treasuries.

Another chart from Guggenheim Investments broadens the asset class picture to see how correlations work differently across different assets.

Source: Guggenheim Investments

The story is the same for bonds. They still offer one of the best hedges against stock market drops. Some pundits tout managed futures, commodities, and other types of alternative investments. Many of these have incredibly high fees and meager returns. Real estate and bonds are the most easily accessible assets that offer a lower correlation with the potential for higher expected returns. Fees are usually much lower than other types of alternative investments.

REITs 101

For a detailed look at how REITs work, I wrote about that in an earlier article with everything you need to know about REIT investing. I'll summarize the differences here.

Publically traded REITs are offered in the form of exchange-traded funds (ETFs) and mutual funds. ETFs trade on stock exchanges like the NYSE and can be bought and sold throughout the day. REIT mutual funds prices are set at the end of each day. The investments held by each can be similar. Some hold residential properties, and others own large shopping centers, strip malls, multi-family units and a wide variety of other types of real estate.

Publically traded REITs must distribute 90% of their income to shareholders. Unlike qualified stock dividends, which are taxed at favorable capital gains tax rates, cash flow from REITS gets taxes at ordinary income tax rates. For high-income investors, that's a higher tax rate. For lower-income taxpayers, it could be more or less, depending on their income. If held in an IRA, investors pay no tax on REIT income while in the IRA. When withdrawn, earnings get taxed at ordinary income tax rates.

Taxes on REITS

Real estate also offers the potential for capital growth. In simple terms, capital growth means you sell the real estate down the road at a price higher than what you paid for it. Like stocks, real estate is considered a capital asset. Capital assets are eligible for potentially more favorable long-term capital gains tax rates when sold. Capital gains tax rates are either 15% or 20%. Here are the capital gains income brackets and tax rates for 2019.

Source: Nerd Wallet

If investors hold real estate investments for one year or more and sell them at a profit, these capital gains tax rates apply to the sale. Real estate can be a valuable asset to grow wealth over time. When sold, taxes may be at lower rates.

Private equity REITs

Private REITs have even greater potential for portfolio protection. In the past, private equity investments were only available to high-net-worth investors or accredited investors.

Accredited investors are those with at least $200,000 in income ($300,000 joint) or a $1,000,00 net worth (exclusive of residence). That cuts off the vast majority of the investing public. Only the 1% get into the game. That’s been the biggest complaint and downside of private equity funds.

The other knock-on these funds is the high fees. In the beginning, they had what’s called the two and twenty fee structure. That meant investors paid a management fee of 2%. If the fund made profits, management took 20% of the profit. Most people feel those fees are expensive. Competition and public pressure have brought down these fees.

Crowdfunded real estate funds

In recent years, crowdfunding has made its way to real estate investing. Crowdfunded REITs are most often offered in private funds; meaning they are not publicly traded. These newer funds register with the SEC as exempt funds, usually under the SEC’s Regulation Crowdfunding. Crowdfunding in real estate, like with individual or small business crowdfunding allows smaller investors into an investment space that hasn’t been available to them in the past.

Crowdfunding provides a way for investors with smaller amounts of money to invest in things commonly only available to the wealthy.

We reviewed our top two choices in the crowdfunding real estate place in an earlier post. The two funds considered were Fundrise and DiversyFund. Both of these funds offer investors a way to invest in quality real estate with a minimum investment of $500.00.

If you’re looking to invest in real estate for growth, DiveryFund is the clear choice in my view.

Private REITs and portfolio protection

Unlike publically traded REITs private equity REITs do not trade on stock exchanges. You won't see their prices on a day to day basis. The volatility isn't there. Whatever percentage you have in privately traded REITs, you won't have to worry about watching them go down with your stocks. Why? These funds do not price their funds on a day to day basis.

In the case of DiversyFund, they invest in multi-family properties across the country. If any region of the country gets hit harder than another, it's unlikely to effect their diversified portfolio. To some degree, Fundrise is similar. The main difference in the two is that DiversyFund only invests for growth in their properties. Fundrise has three choices in real estate portfolios – income, growth and income, and growth.

If an investor's goal is to grow wealth, income from the real estate should be a secondary concern. Wealth comes from the long-term growth of assets. That is the DiversyFund philosophy in a nutshell. Portfolio protection comes from owning an asset that's not correlated with the stock and bond markets. It isn't subject to the ups and downs of the daily pricing model required on the stock exchanges. k

Private equity through crowdfunding opens the door for the types of real estate formerly available only to the wealthy. It's a win-win proposition. Plus, they have a much lower correlation to the equity markets. David Swensen, manager of the Yale Endowment fund had 15.3% of his fund invested in direct real estate investments (private equity). They are not liquid, have a low correlation with the stock market and provide outsized returns to the fund.

Smaller investors now have access to private REITs via crowdfunded real estate funds.

Final thoughts

If you're an investor who has never thought about portfolio protection, I'd encourage you to consider how that might work for you. It's only a matter of time before we have a market correction. It's more likely than not that correction could turn into a bear market, defined by a 20% drop in stocks. As a reminder, this isn't a warning or prediction that stocks are going to drop like a rock tomorrow, next month, or next year. It is a reminder that history shows us it will happen at some point.

Bonds haven't paid any meaningful interest during the time of the current bull market. It's one of the driving forces behind keeping the bull market going. Since investors can't find meaningful income from bond investments, they move more money into stocks to gain a higher return. With that move comes additional risk. Many have forgotten about (or never experienced) that kind of risk.

I'm suggesting that now may be a good time to review the risk your taking. Stress-test your portfolio to see how it would fare in a 2008 type of financial meltdown. Consider adding high-quality bonds and private real estate to your portfolio. When the next downturn comes, you'll be glad you did.