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 (MPT) supports this thesis, and can provide a useful guiding framework for asset allocation—not just for large institutional investors but for individuals as well.
A Brief Definition of Modern Portfolio Theory
- Modern portfolio theory seeks to maximize returns at any fixed level of risk or, conversely, to minimize risk at any fixed level of return.
- Modern portfolio theory uses mean variance optimization to assess the impact of cross-asset correlations on portfolio risk-adjusted returns.
- Exposure to alternative assets can help to minimize cross-asset correlations, potentially reducing risk at the portfolio level.
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—0r, inversely, minimizing overall risk for a given target portfolio return.
MPT, 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.
Modern Portfolio Theory and Investment Analysis
Consider a hypothetical fictional investor (let’s call her Stephanie, a lawyer in her early thirties). Stephanie currently holds a large amount of stock in Tech Company A, just received her holiday bonus, and is looking to grow her portfolio wisely. She does not want to put more money into Tech Company A (though the stock is performing well) because she understands intuitively that she should diversify her portfolio as it grows. Stephanie is deciding between putting her money in Tech Company B or devoting her bonus to passive real estate investments. Which investment choice is preferable with respect to the risk-adjusted return potential of Stephanie’s portfolio?
In order to employ modern portfolio theory to inform her allocation choices, she’ll need to gather a set of estimated asset performance figures: the expected return of each asset within her potential portfolio; the volatility of each asset class (as represented by their standard deviation from their expected mean return); the correlation between these asset classes; and their covariance with one another (as defined by the product of their volatilities and correlation with one another).
Stephanie arrives at the following regarding the expected return, volatility, and correlations of her portfolio’s constituent asset classes:
From here, Stephanie can then calculate the covariance of these assets using the covariance formula COVij=SiSjCij where S is the time-series standard deviation of periodic total returns (volatility), and C is the covariance between the two assets i and j. As such, Stephanie arrives at the following covariances for the constituent asset classes of her portfolio:
To capture the true impact of modern portfolio theory, is it important to examine what the expected return and standard deviations of portfolios with these potential allocations would be. Below are the expected return and standard deviations of Stephanie’s two portfolio options. Portfolio 1 consists of 70% Tech Company A stock and 30% Tech Company B stock. Portfolio 2 consists of 70% Tech Company A stock and 30% real estate.
Note also that many investors may have little confidence in an expected return for a publicly traded stock. Two fictional stocks are used here for illustrative purposes, but ETFs or indexes may be more appropriate for such an analysis.
Despite the fact that both portfolios have the exact same expected return and risk profile, the portfolio containing real estate has a significantly lower overall risk profile than the portfolio containing Tech Company B, an asset that is similar in nature and highly correlated to Stephanie’s main holding of Tech Company A. True diversification considers not just the risk/return profiles of asset classes and assets within the portfolio, but also the correlation of the individual assets within the portfolio.
The figures above, albeit simplified, make clear the impact that modern portfolio theory practice can have. As you can imagine, the larger and more varied the portfolio, the more complex the calculations and the more powerful the output can be. Excel and other specialized software can assist with more complex mean variance optimizations.
Like David Ricardo’s theory of comparative advantage in trade, modern portfolio theory is a simple, elegant concept with profound real-world implications. While it may not be practical or feasible to employ sophisticated formulas to rebalance your portfolio, the take-home principles of modern portfolio theory are worth keeping in mind when any new asset or allocation mix is considered: for any level of expected aggregate return, the degree of correlation between assets and asset classes within a portfolio should be minimized.
The basic premise is worth keeping in mind as you are adding individual private real estate assets to your portfolio. While all real estate asset classes are subject to macroeconomic factors to some degree, individual properties and local real estate markets are also subject to microeconomic factors and sectoral economic trends. If, for example, you are considering two private real estate assets with very similar risk/return profiles, modern portfolio theory would prescribe that you select the one that bears lower correlation with other assets in your portfolio – either the real estate portion or your portfolio as a whole. This may mean diversifying away from a geographic market where you already have exposure, or allocating to an asset whose investment thesis is supported by economic trends contrary to your existing holdings — for example, self-storage vs. ground-up luxury condos.
Limitations of Modern Portfolio Theory
In its original form, MPT uses standard deviation as a proxy for risk, which investors seek to mitigate within the framework. Using standard deviation as a measure of risk, however, implies that a better-than-average return is as undesirable as a worse-than-expected return of the same magnitude. Furthermore, using the normal distribution to model the pattern of potential investment returns makes investment results with more upside than downside appear more risky than they really are, with the opposite true as well. This can lead investors to misunderstand the potential ‘upside’ or ‘downside’ of a particular investment when considering only traditional modern portfolio theory methodology.
Some academics and portfolio managers have taken to incorporating a metric called “downside risk,” which incorporates an investor’s goal return and defines risk as those outcomes that do not achieve that goal. The statistic is calculated in a similar manner to standard deviation, but it only accounts for results that lie below the investor’s desired return hurdle. The metric measures the volatility of results below the target return. This modified framework is sometimes referred to as “post-modern portfolio theory” (PMPT).
MPT and the Current Landscape of Alternative Investments
Diversification across uncorrelated assets is the cornerstone of Modern Portfolio Theory, so it’s no surprise that acolytes of MPT have taken an active interest in diversifying across a growing spectrum of alternative assets.
Alternative investments are broadly defined as securities transacted in private, inefficient markets. They are typically less liquid than public market assets (like publicly traded stocks). While public market vehicles like index funds can offer access to “beta” (an investment in the broad health of the economy or sector of the economy), private-market alternatives offer access to “alpha,” or return potential derived from skill in management and the exploitation of market inefficiencies.
Performance of a privately-held commercial real estate asset, for example, tends to depend on the soundness of location and business plan and the skill and resources of the Sponsor and/or developer, rather than market swings. By definition, then, alternative assets exhibit low correlations with traditional assets, making them attractive additions to a portfolio when evaluated through the lens of Modern Portfolio Theory.
Recent studies have supported this assertion, including a JPMorgan report that analyzed performance of portfolios with various allocation percentages to alternative investments (including private real estate) over a 24+ year period, from 1990 to 2024:
According to the Future of Alternatives 2028 report by research firm Preqin, the global alternative investments market is expected to reach $24.5 trillion compared to approximately $16.3 trillion at the end of 2023.
Going into 2025, alternative investments may be set to gain traction as investors search for ways to diversify against market uncertainty. Deregulation, the Fed’s continued lowering of interest rates, and the picking up of mergers and acquisitions activity are all factors that could boost interest in private-market alternatives among individual investors.
All of the above point to the continued relevance of alternative assets, like private real estate, when considered within the Modern Portfolio framework. Unfortunately, individual investors remain severely under-allocated versus institutional investors like pensions and endowments.
EquityMultiple levels the playing field for individual investors by offering high-quality, private-market real estate assets at relatively low minimums. (In previous years, alternative investments were almost exclusively available to institutions and ultra-high-net-worth individuals. The playing field for alternative investments has changed dramatically, however, with the advent of real estate crowdfunding platforms after the JOBS Act of 2012. This made the fractional ownership of alternative assets, like commercial real estate, accessible to all individual accredited investors.)
It should be noted that alternative investments still carry risk, including liquidity risk. Again, alternative assets tend to exhibit a greater “alpha,” so it’s important for investors to understand the quality of management and the underlying asset, as well as all risk factors; returns tend to be less correlated to the beta of traditional market investments and are more dependent on the individual manager’s skill.
For more on alpha, beta, and mitigating exposure to systematic risk through allocation to alternative assets, please refer to this article.
Post-Script: Modern Portfolio Theory Today
Current financial headlines have not changed anything about the fundamental utility of the MPT framework. More than six decades after its inception, MPT continues to provide a valuable framework for investors navigating today’s complex financial markets. The theory’s emphasis on diversification and risk-adjusted returns aligns well with the current need for robust portfolio strategies in an ever-evolving investment landscape.
