Modern Portfolio Theory describes how investors construct portfolios to maximize returns while managing exposure to market risk. Since it’s definition, it has become the leading practice in investments today.
MPT theory was pioneered by Harry Markowitz, whose paper on the subject was published in 1952 by the Journal of Finance. He discovered that investment strategies of the time focused exclusively on return - they did not account for risk.
In response to this realization, Markowitz went on to write "Portfolio Selection," which sparked interest in portfolio diversification. Its main premise was that diversified portfolios perform better than those which choose only investments with the highest anticipated return. Though this is widely accepted today, at the time, it was a revolutionary concept. Markowitz later received the Nobel Prize for developing Modern Portfolio Theory.
Understanding Risk and Return
Risk and return are the two main components of Modern Portfolio Theory. Though fundamental investment terms, they are worth mentioning.
Return: The profit you make on an investment is the return. It could be capital gains from:
- Dividends paid from companies you have ownership in
- Appreciation of an investment, or bond payments upon maturity.
Risk: The chance you take that a particular investment will not provide the desired return. In general, stocks have a higher risk level than bonds, but every investment carries some type of risk. Risk can also refer to “volatility,” or the amount an asset’s value rises and falls with market fluctuations.
Modern Portfolio Theory Assumptions
Modern Portfolio Theory assumes that investors see risk and return as directly related - you need to take a higher risk in order to receive higher returns.
Furthermore, the theory suggests that diversifying investments can reduce risk without reducing your returns. In other words, an investor should choose the portfolio with the lower risk without sacrificing the return.
Other assumptions of MPT include:
- Investors are in the market to maximize returns
- Investors don't take unnecessary risk
- All investors understand the expected returns
- Commissions are not included in the decision
- All investors have the same information at their disposal
The Importance of Diversification
When you diversify your portfolio, you choose investments that aren't correlated. They could be as different as investing in stocks and bonds or as simple as choosing ETFs in different economic sectors.
If you choose investments within the same sector, you run the risk of them both reacting negatively to the same bad economic factors.
Choosing investments in different industries and/or investment types diversifies that risk. In other words, the risk of these investments being affected by the same economic factors is very slim.
Real Estate, a critical part of MPT?
Here are some of the key reasons why long term real estate investments are a valuable part of a well-balanced investment portfolio:
Competitive Risk-Adjusted Returns
According to the data collected by the National Council of Real Estate Investment Fiduciaries (NCREIF) in July 2018, the private market commercial real estate had returned an average of 9.85% over the past five years. This high-reward performance was achieved, together with a lower volatility relative to bonds and equities, for highly competitive risk-adjusted returns.
Critics have often argued that low volatility characteristics of real estate are the result of infrequent transactions and the value of the property is often determined by third-party appraisals, but these tend to lag the market.
The appraisals and infrequent transaction result in a smoothing of returns, as the reported property values underestimate the market values in an upturn leading to overestimate market values in a downturn.
Stable and Attractive Income Return
A key feature of investment in real estate would be the significant proportion of the total return from the rental income over a long-term period. Over the duration of a 30-year period (from 1977 to 2007), almost 80% of the total U.S. real estate return was derived from income flows helping reduce the volatility as investments that relied more on income return tended to be less volatile than the ones that relied more on capital value return.
Highly Tangible Asset Value
Like the name implies, and unlike stocks and bonds, real estate is always backed by brick and mortar - something ‘real’. This helps reduce the extent to which an investor’s interest is dependent on the competence and integrity of the managers and debtors. The asset is always there, and even during the case of recessions or depressions, some value is retained in the land.
Another massive benefit of investing in real estate is the diversification potential it provides. Real estate has a negative correlation with many major asset classes. Thus, the addition of real estate to a diversified portfolio will lower portfolio volatility and provide higher returns per unit of risk.
Real estate’s inflation hedging capability stems from the positive relationship between the GDP growth and real estate demand. As the economies expand, the demand for real estate drive the rents up, and this, in turn, translates to higher capital values. Therefore, real estate does a good job of maintaining the capital’s power as it passes the inflationary pressure on to the tenants, and by incorporating the inflationary pressure in the form of capital appreciation.
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