According to Investopedia diversification is ‘a technique that reduces risk by allocating investments among various financial instruments, industries, and other categories. It aims to maximise returns by investing in different areas that would each react differently to the same event.’
Most investment professionals agree that, although it does not guarantee against loss, diversification is the most important component of reaching long-term financial goals while minimising risk. Diversification when investing in private mortgages is no different.
A ‘direct’ investment into a private mortgage has the benefit of allowing the investor to choose which loan they want to put their money into. This gives them the opportunity to decide which loan terms, rate of return and security suits their risk profile. However, investors also run the risk of having all their eggs in one basket.
The prospect of choosing a direct investment isn’t as alluring if it meant you had to tie up all your capital in one opportunity. There are certainly some pitfalls in placing all your money into a single investment. You need to contemplate the possibility of the borrower going into default. If this were the case, how exposed are you financially?
For most investors, there is greater comfort in spreading funds across a diversified portfolio with a blend of risk and reward ratios. In order to diversify your portfolio when investing in private mortgages you can invest in a pooled mortgage fund which allows your funds to be distributed across a range of different loans. The benefits of a diversified pooled mortgage fund include:
- Managing risk. When you distribute your funds over several mortgages and one of the borrowers goes into default, the interest is capitalised instead of being paid by the borrower. There can be a lag time to recoup the capitalised interest, so the other performing loans within the portfolio support the regular distribution payments. In other words, you are not left vulnerable to the actions of a single borrower.
- Improved Return on Investment: If your portfolio is comprised of first mortgages it may glean a lower rate of return than a portfolio also including second mortgages. A pooled fund with a blend of first and second mortgages, can result in a better ROI and balance the risk/reward ratio.
- Passive investment: Investing in a diversified mortgage fund run by an experienced mortgage manager means you can sit back and relax while they source loan opportunities and then manage each loan from start to finish.
- Regular income: A pooled mortgage fund will deliver regular monthly or quarterly income based on the returns from the portfolio of loans. If you invested in one direct loan at a time there would be downtime between loans which means your money won’t be working for you all the time.
Diversification of your investment portfolio can help to manage risk, however it should be noted that risk is inherent in any type of investing. That’s why working with an experienced investment manager is critical in helping you to minimise risk and maximise return – and allowing you to sleep at night.
If investing in a diversified portfolio is something of interest to you, please register your interest at www.activepropertygroup.com.au/register/ for more information.
This information is of a general nature and does not constitute professional advice. You should always seek professional advice in relation to your particular circumstances.
And while we’re on this topic, here’s a video from our resident private mortgage investment expert Tony Barbone discussing the importance of diversification when investing in private mortgages.