How many properties to buy?

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From: Andrew Scott


I guess this message could also be titled "diversification considered harmful?" - there's a bit of maths here, but I hope it doesn't scare anyone off. I worked this out on a spreadsheet, so it couldn't be that scary.

Diversification: the idea that multiple assets should be bought in order to spread money over a diverse range of areas (asset classes, suburbs, styles, etc.) This is a commonly accepted part of financial planning. But *what* exactly is the good stuff that comes from diversification?

By diversifying, you are reducing the chance that in the short term, you lose so much through failed investment that you can't achieve what you want. In order words, diversifying reduces risk.

Obviously, this oversimplifies things. Different investment philosophers from Kiyosaki to Buffett have claimed good and bad things for diversification. Who is right?

My spreadsheet maths suggests that if you are only diversifying within your property assets, then going from one property to two properties makes it less likely that you'll achieve a return on your total assets that is within 10% of the expected return.

The expected return is the weighted average of all possible returns by their probability. So, if you have two outcomes, one of which has a 10% chance (returning $1000) and the other a 90% chance (returning $2000), then the expected return is $1900.

Also, adding properties to your portfolio will probably make it even less likely that you'll achieve a return of within 10% of the expected return. Eventually you will pass a threshold, and you will be more likely to achieve higher returns, but it may not be until you've acquired five or more properties (depending on probabilities)!

However, it is not all bad. You'll also be increasingly less likely to lose the lot. But you will be increasingly less likely of having everything go your way too (easy enough to achieve when you only have one property). You will probably have a property or two end up in the doldrums.

But I've been thinking that perhaps this implication of diversity could be one explanation of why on this forum there are two main types: those with one investment property, and those will a large number of them. The problem of diversification would indicate that a kind of chasm, where for a while you are less likely to get dream returns. Once you've crossed it, by amassing a significant portfolio, you're set.

Does this match what people have observed in the Real World?

(I have attached the Excel spreadsheet with my workings..)

Andrew Scott
 
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Reply: 1
From: Rolf Latham


Hi Andrew

Do you have anyone named Sim in your family tree ??

I notice some remarkable similarities :eek:)

My experience from clients is that once they have found something that has worked for them they tend to zero in on that type of property, even down to the suburb if they can.

Myth would have it that this can be a risk mitigation strategy. Certainly a lot less risky than buying soemthing you dont know in a foreign city.

Ta

Rolf
 
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Reply: 2
From: Owen .


Andrew,

Your final comment on there being a gap between owning 1 IP and multiple IP's is what I am finding. 1 IP is easy to manage financially but as I buy more it is getting harder although the deals are getting better. I can't wait until I have a larger portfolio as, like you said, the numbers will work a lot better. The big pay off will be the flexibility provided by having a larger pool of properties for both growth and income.

I'm definitely going through that transitional period now.

Owen

"Gambling promises the poor what property performs for the rich – something for nothing"
 
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