EquityMultiple’s Real Estate Team works tirelessly to evaluate individual real estate investments, assessing return potential versus risk factors. But what of the broader picture of an investment portfolio? Experienced investors will seek to maximize return potential relative to risk at the portfolio level, whether that portfolio is comprised of a traditional allocation to stocks and bonds, or is more diversified. As we will show, there is analytic and historical evidence to support allocating a greater share to private real estate: a greater proportion than is reflected in the portfolios of most individual investors. Modern portfolio theory supports this thesis, and can provide a useful guiding framework for asset allocation, not just for large institutional investors but for individuals as well.
Modern Portfolio Theory and Investment Analysis
Modern portfolio theory refers to the quantitative practice of asset allocation that maximizes projected (ex-ante) return for a portfolio while holding constant its overall exposure to risk. Or, inversely, minimizing overall risk for a given target portfolio return. The theory, first put forth by Harry Markowitz in his paper “Portfolio Selection” in the 1952 Journal of Finance, prescribed diversifying across uncorrelated assets to reduce the overall risk exposure of the portfolio.
The theory uses a mathematical process called “mean variance optimization”, thereby considering the covariance of constituent assets or asset classes within a portfolio, and the impact of an asset allocation change on the overall expected risk/return profile of the portfolio.
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