The Return Due to Diversification of Real Estate to the U.S. Mixed-Asset Portfolio

By Lee, Stephen L. | Journal of Real Estate Portfolio Management, January-April 2005 | Go to article overview

The Return Due to Diversification of Real Estate to the U.S. Mixed-Asset Portfolio


Lee, Stephen L., Journal of Real Estate Portfolio Management


Executive Summary. Booth and Fama (1992) observe that the compound return of a portfolio is greater than the weighted average of the compound returns of the individual investments, a difference referred to as the return due to diversification (RDD). Thus, assets that offer high RDD to a portfolio should be particularly attractive investments for long-term investors. This paper shows that U.S. direct real estate is just such an asset; however, the results are dependent on the percentage allocation to direct real estate and the asset class replaced.

Introduction

The argument for including real estate in the mixed-asset portfolio is typically made on its diversification benefits rather than on its contribution to the return of the portfolio. Indeed, in a recent paper Hudson-Wilson and Hopkins (2000) find that direct real estate in the United States offered investors such poor performance compared with either stocks or bonds that the authors can see little case for real estate in the mixed-asset portfolio. The argument of Hudson-Wilson and Hopkins can be criticized on at least three grounds. First, the data used only covers the period 1990 to 2000, a period of spectacular growth in the performance of shares on the back of the dot-com boom, which is unlikely to be representative of performance of stocks in the long run. The reversal in share prices since 2001 testifies to this. Yet it is the long-run returns that investors need to examine in deriving the strategic asset allocation (SAA) of the mixed-asset portfolio. Second, when an investor is contemplating the addition of an asset to the mixed-asset portfolio they need to consider the contribution the asset makes to the risk and return performance of the portfolio as a whole, rather than its individual risk and return characteristics. Third, institutional investors should be more concerned with the terminal wealth of their portfolio of investments rather than the individual asset's past performance, as it is from the terminal wealth of the fund that the institutional will meet its future contractual obligations (Radcliffe, 1994). Thus, for those institutionals with long-run holding periods, the terminal wealth or compound return should be seen as the primary measurement of performance. Assets that contribute most to the compound return, or terminal wealth, of the mixed-asset portfolio should present the greatest attraction to institutional investors. Hence, when deciding on the SAA of the mixed-asset portfolio investors should focus their attention on those assets that contribute most to the compound return of the mixed-asset portfolio.

This does not mean that investors should concentrate their allocations in assets with the highest expected returns. Booth and Fama (1992) show that although the compound return of an investment (asset or portfolio) is an increasing function of its expected return, it is also a decreasing function of its risk (variance). In other words, investments with higher expected returns and high risks do not necessarily provide higher compound returns to the portfolio than investments with lower expected returns and lower risks. Moreover, Booth and Fama show that the compound return of a portfolio is greater than the weighted average of the individual compound returns of the investments. Booth and Fama refer to this difference as the "return due to diversification" (RDD) of the investment within the portfolio. This counterintuitive result stems from the fact that although variance is an appropriate measure of risk of a portfolio it is not the relevant measure of the risk of the investment within a portfolio. The risk of an investment in a portfolio should be measured by its covariance with the portfolio. Thus, an asset with a low expected return but a low covariance may be more desirable, in terms of the compound returns of the portfolio, than an asset with a higher expected return but a high covariance.

Previous studies find that real estate is an asset that displays good returns and low covariance within the mixed-asset portfolio (see Seiler, Webb and Myer, 1999; and Hoesli, MacGregor, Adair and McGreal, 2001 for comprehensive reviews). …

The rest of this article is only available to active members of Questia

Sign up now for a free, 1-day trial and receive full access to:

  • Questia's entire collection
  • Automatic bibliography creation
  • More helpful research tools like notes, citations, and highlights
  • Ad-free environment

Already a member? Log in now.

Notes for this article

Add a new note
If you are trying to select text to create highlights or citations, remember that you must now click or tap on the first word, and then click or tap on the last word.
One moment ...
Default project is now your active project.
Project items

Items saved from this article

This article has been saved
Highlights (0)
Some of your highlights are legacy items.

Highlights saved before July 30, 2012 will not be displayed on their respective source pages.

You can easily re-create the highlights by opening the book page or article, selecting the text, and clicking “Highlight.”

Citations (0)
Some of your citations are legacy items.

Any citation created before July 30, 2012 will labeled as a “Cited page.” New citations will be saved as cited passages, pages or articles.

We also added the ability to view new citations from your projects or the book or article where you created them.

Notes (0)
Bookmarks (0)

You have no saved items from this article

Project items include:
  • Saved book/article
  • Highlights
  • Quotes/citations
  • Notes
  • Bookmarks
Notes
Cite this article

Cited article

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

(Einhorn, 1992, p. 25)

(Einhorn 25)

1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited article

The Return Due to Diversification of Real Estate to the U.S. Mixed-Asset Portfolio
Settings

Settings

Typeface
Text size Smaller Larger Reset View mode
Search within

Search within this article

Look up

Look up a word

  • Dictionary
  • Thesaurus
Please submit a word or phrase above.
Print this page

Print this page

Why can't I print more than one page at a time?

Full screen

matching results for page

Cited passage

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn, 1992, p. 25).

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn 25)

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences."1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited passage

Welcome to the new Questia Reader

The Questia Reader has been updated to provide you with an even better online reading experience.  It is now 100% Responsive, which means you can read our books and articles on any sized device you wish.  All of your favorite tools like notes, highlights, and citations are still here, but the way you select text has been updated to be easier to use, especially on touchscreen devices.  Here's how:

1. Click or tap the first word you want to select.
2. Click or tap the last word you want to select.

OK, got it!

Thanks for trying Questia!

Please continue trying out our research tools, but please note, full functionality is available only to our active members.

Your work will be lost once you leave this Web page.

For full access in an ad-free environment, sign up now for a FREE, 1-day trial.

Already a member? Log in now.