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21.2:
FOR RIGOROUS QUANTIFICATION,
PORTFOLIO THEORY ASSUMES:
YOUR OBJECTIVE FOR YOUR OVERALL WEALTH
PORTFOLIO IS:
MAXIMIZE EXPECTED FUTURE RETURN
MINIMIZE RISK IN THE FUTURE RETURN
P
RETURN
RISK
RETURN
RISK
21.2.2
RETURN
P
DOMINATES
"Q"
Q
DOMINATED
BY
"Q"
RISK
Exh.21-3: PORTFOLIO THEORY TRIES TO
MOVE INVESTORS FROM POINTS LIKE "Q"
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Section 21.2.2
III. PORTFOLIO THEORY AND DIVERSIFICATION...
"PORTFOLIOS" ARE "COMBINATIONS OF ASSETS".
PORTFOLIO THEORY FOR (or from) YOUR GRANDMOTHER:
DONT PUT ALL YOUR EGGS IN ONE BASKET!
WHAT MORE THAN THIS CAN WE SAY? . . .
(e.g., How many eggs should we put in which baskets.)
In other words,
GIVEN YOUR OVERALL INVESTABLE WEALTH, PORTFOLIO THEORY TELLS YOU HOW
MUCH YOU SHOULD INVEST IN DIFFERENT TYPES OF ASSETS. FOR EXAMPLE:
WHAT % SHOULD YOU PUT IN REAL ESTATE?
WHAT % SHOULD YOU PUT IN STOCKS?
TO BEGIN TO RIGOROUSLY ANSWER THIS QUESTION, CONSIDER...
r P = wn r n
n=1
Expected
Return
VAR P wi w j COVij
I 1 J 1
10%
7.5%
5%
A
5%
10%
Volatility
< 7.5%
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10
This Diversification Effect is greater, the lower is the correlation among the
assets in the portfolio.
NUMERICAL EXAMPLE . . .
SUPPOSE REAL ESTATE HAS:
EXPECTED RETURN
= 8%
RISK (STD.DEV)
= 10%
THEN A PORTFOLIO WITH SHARE IN REAL ESTATE & (1-) SHARE IN STOCKS WILL
RESULT IN THESE RISK/RETURN COMBINATIONS, DEPENDING ON THE CORRELATION
BETWEEN THE REAL ESTATE AND STOCK RETURNS:
C = 100%
C = 25%
C = 0%
C = -50%
rP
sP
rP
sP
rP
sP
rP
sP
0%
12.0% 15.0% 12.0% 15.0% 12.0% 15.0% 12.0% 15.0%
25%
11.0% 13.8% 11.0% 12.1% 11.0% 11.5% 11.0% 10.2%
50%
10.0% 12.5% 10.0% 10.0% 10.0%
9.0% 10.0%
6.6%
75%
9.0% 11.3%
9.0%
9.2%
9.0%
8.4%
9.0%
6.5%
100%
8.0% 10.0%
8.0% 10.0%
8.0% 10.0%
8.0% 10.0%
where:
C = Correlation Coefficient between Stocks & Real Estate.
(This table was simply computed using the formulas noted previously.)
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This Diversification Effect is greater, the lower is the correlation among the
assets in the portfolio.
Correlation = 100%
12%
11%
1/4 RE
10%
1/2 RE
9%
3/4 RE
8%
9%
10%
11%
12%
13%
Portf Risk (STD)
14%
15%
14%
15%
Correlation = 25%
12%
11%
1/4 RE
10%
1/2 RE
3/4 RE
9%
8%
9%
10%
11%
12%
13%
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13
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Exh.21-5a: For example, a portfolio of 50% large stocks & 50% small stocks would
not have provided much volatility reduction during 1970-2010 (from large stk vol 18%
& small stk vol 23% to half/half vol 19%) :
15
Exh.21-5b: Here the portfolio of 50% bonds & 50% real estate would have provided
more diversification during 1970-2010, with less volatility than either asset class alone
even though a very similar avg total return:
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VAR P wi w j COVij
Covariance = Stdev(i)*Stdev(j)*Correl(I,j)
I 1 J 1
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Though hard data is lacking, we would probably have to go back a further 30+ yrs to find a third double-down year:
1/30 chance any one year both down
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20
21
41 yrs history:
5 LgStk, 7
SmStk, 3 RE, 2
LTGBnd;
2 coincide
across all
Fat tail magnitude: Real estate avg big bear 2/3 that of
stocks, half the frequency, and more regular (predictable)
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23
Of the 8 bears listed here, only 2 afflicted all three risky asset
classes (and actually also bonds too).
Two market-wide big bears, separated by 33 years.
(Clearly the Great Depression, 40 years earlier, also did that.)
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Fat tail magnitude: Real estate avg big bear 2/3 that of
stocks, half the frequency, and more regular (predictable)
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SUMMARY UP TO HERE:
DIVERSIFICATION AMONG RISKY ASSETS ALLOWS:
GREATER EXPECTED RETURN TO BE OBTAINED
FOR ANY GIVEN RISK EXPOSURE, &/OR;
LESS RISK TO BE INCURRED
FOR ANY GIVEN EXPECTED RETURN TARGET.
(This is called getting on the "efficient frontier".)
PORTFOLIO THEORY ALLOWS US TO:
QUANTIFY THIS EFFECT OF DIVERSIFICATION
IDENTIFY THE "OPTIMAL" (BEST) MIXTURE OF RISKY
ASSETS
(It also allows to quantify how much it matters.)
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SUM
(1/2)(1/2)(.15)(.15)(1.00)
(1/2)(1/3)(.15)(.08)(0.30)
(1/2)(1/6)(.15)(.10)(0.25)
(1/2)(1/3)(.15)(.08)(0.30)
(1/3)(1/3)(.08)(.08)(1.00)
(1/3)(1/6)(.08)(.10)(0.15)
(1/2)(1/6)(.15)(.10)(0.25)
(1/3)(1/6)(.08)(.10)(0.15)
(1/6)(1/6)(.10)(.10)(1.00)
0.0056
0.0006
0.0003
0.0006
0.0007
0.0001
0.0003
0.0001
0.0003
= 0.0086
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Not this.
Min-vol
portf
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Portf Volatility
35
36
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21.2.6
Major Implications of Portfolio Theory for Real Estate Investment
MinVar
Portf Retn
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Section 21.3
VII. INTRODUCING A "RISKLESS ASSET"...
IN A COMBINATION OF A RISKLESS AND A RISKY ASSET, BOTH
RISK AND RETURN ARE WEIGHTED AVERAGES OF RISK AND
RETURN OF THE TWO ASSETS:
Recall:
43
If either i or j is riskless . . .
E[rj]
E[ri]
si
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sj
Volatility
44
VAR P wB wBVAR B
Expected
Return Red line is now straight
(on top of green)
10%
7.5%
5%
This is
now 0%
(not 5%
anymore)
A
5%
10%
Volatility
< 7.5%
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45
46
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NUMERICAL EXAMPLE
SUPPOSE:
RISKFREE INTEREST RATE = 5%
STOCK EXPECTED RETURN = 15%
STOCK STD.DEV. = 15%
________________________________________________________
IF RETURN TARGET = 20%,
BORROW $0.5
INVEST $1.5 IN STOCKS (v = 1.5).
EXPECTED RETURN WOULD BE:
(1.5)15% + (-0.5)5% = 20%
RISK WOULD BE
(1.5)15% + (-0.5)0% = 22.5%
________________________________________________________
IF RETURN TARGET = 10%,
LEND (INVEST IN BONDS) $0.5
INVEST $0.5 IN STOCKS (v = 0.5).
EXPECTED RETURN WOULD BE:
(0.5)15% + (0.5)5% = 10%
RISK WOULD BE
(0.5)15% + (0.5)0% =
7.5%
___________________________________________________________
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BORROW
V=150%
LEND
V=100%
V=50%
V = WEIGHT IN STOCKS
V=0
0%
0%
7.5%
15%
RISK (STD.DEV.)
22.5%
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20%
10%
50
Exptd Return
20%
15%
10%
5%
0%
0%
5%
10%
15%
20%
25%
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rj
rP
ri
P
i
rf
Risk(Std.Dev.of Portf)
rj
rP
ri
P
i
rf
Risk(Std.Dev.of Portf)
THUS,
ALL EFFIC. PORTFS ARE COMBINATIONS OF JUST 2 FUNDS:
RISKLESS FUND (long or short position) + RISKY FUND "P" (long position).
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21.3.2
HOW DO WE KNOW WHICH COMBINATION OF RISKY ASSETS IS
THE OPTIMAL ALL-RISKY PORTFOLIO P?
IT IS THE ONE THAT MAXIMIZES THE SLOPE OF THE STRAIGHT
LINE FROM THE RISKFREE RETURN THROUGH P. THE SLOPE
OF THIS LINE IS GIVEN BY THE RATIO:
Portfolio Sharpe Ratio = (rp - rf) / sP
MAXIMIZING THE SHARPE RATIO FINDS THE OPTIMAL RISKY
ASSET COMBINATION. THE SHARPE RATIO IS ALSO A GOOD
INTUITIVE MEASURE OF RISK-ADJUSTED RETURN FOR THE
INVESTORS WEALTH, AS IT GIVES THE RISK PREMIUM PER UNIT
OF RISK (MEASURED BY ST.DEV).
THUS, IF WE ASSUME THE EXISTENCE OF A RISKLESS ASSET,
WE CAN USE THE 2-FUND THEOREM TO FIND THE OPTIMAL
RISKY ASSET MIXTURE AS THAT PORTFOLIO WHICH HAS THE
HIGHEST "SHARPE RATIO".
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54
RE share
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1.0
rP
rp-rf
15.0%
14.5%
14.0%
13.5%
13.0%
12.5%
12.0%
11.5%
11.0%
10.5%
10.0%
10.0%
9.5%
9.0%
8.5%
8.0%
7.5%
7.0%
6.5%
6.0%
5.5%
5.0%
sP
15.0%
13.8%
12.6%
11.6%
10.7%
10.0%
9.5%
9.2%
9.2%
9.5%
10.0%
Sharpe
Ratio
66.7%
68.9%
71.2%
73.2%
74.6%
75.0%
73.8%
70.5%
65.1%
58.0%
50.0%
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Bonds; 38
CRE; 9
Stocks; 15
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Defined
Contribution (DC):
$8.6 trillion
& growing.
DB plans often fall short of their DC plans need new vehicles for
stated CRE targets
making CRE investments.
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Source:DharandGoetzmann2004surveyofU.S.pensionfundsforPREA.
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Correct for appraisal-smoothing, private mkt lag, variable liquidity (as in HW3).
Extra transaction costs, illiquidity penalties;
Long-term horizon risk & returns;
Net Asset-Liability portfolio framework;
Investor constrained to over-invest in owner-occupied house as investment.
But even with such extensions, optimal R.E. share often substantially exceeds
existing P.F. allocations to R.E. (approx. 3% on avg.*)
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64
Appendix 21A
I. REVIEW OF STATISTICS ABOUT PERIODIC TOTAL RETURNS:
(Note: these are all time-series statistics: measured across time, not across assets within a
single point in time.)
"1st Moment" Across Time (measures central tendency):
MEAN, used to measure:
Expected Performance ("ex ante", usually arithmetic mean: used in portf ana.)
Zero
"Efficient" Market (prices quickly reflect full information; returns
lack predictability) Like securities markets
(approximately).
Positive
"Sluggish" (inertia, inefficient) Market (prices only gradually
incorporate new info.) Like private real estate
markets.
Negative
"Noisy" Mkt (excessive s.r. volatility, price "overreactions")
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Like securities markets (to some extent).
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Line B:
G-Mean/Yr = 8.9%
A-Mean/Yr = 8.9%
Ann. Vol. = 0%
Line A:
G-Mean/Yr = 8.9%
A-Mean/Yr = 12.2%
Ann. Vol. = 18%
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Line B:
G-Mean/Yr = 6.4%
A-Mean/Yr = 6.4%
Ann. Vol. = 0%
Line A:
G-Mean/Yr = 6.4%
A-Mean/Yr = 9.7%
Ann. Vol. = 18%
68
LTG Bonds
Private
Real Estate
Mean (arith)
13.2%
9.6%
10.0%
Std.Deviation
17.5%
12.5%
10.9%
100%
3%
12%
100%
-4%
1st Moments
Correlations:
S&P500
LTG Bonds
Priv. Real Estate
2nd Moments
100%
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