Modern Portfolio Theory: How to Construct your Portfolio like the Pros

Modern Portfolio Theory is the financial version of “don’t put all your eggs in one basket”, and suggests 10-20% be invested into alternative investments.

There are plenty of financial pundits who offer advice on how to “invest like the pros.” However, if you’re an individual investor looking to improve your investment portfolio’s performance, understanding the Modern Portfolio Theory -- an investment strategy used by institutional investors -- could prove beneficial.

The Modern Portfolio Theory is a finance theory that seeks to maximize portfolio returns for a given level of risk by carefully allocating capital across multiple asset classes, including stocks, bonds, and alternative assets including real estate. This diversification of asset classes exploits their varying degrees of correlation to the economy and to each other, meaning the degree to which their returns move in the same direction (or opposing directions). For example, if the returns on your stock investments are declining, but the bond market’s returns are holding steady, or even producing positive returns, you may still earn a net neutral or positive return overall. Or say news about inflation risk or short-term interest rates is impacting the bond market, the performance of the real estate assets in your portfolio might be unaffected because they are less tied to national macroeconomic factors and more closely correlated to regional market influences.

Essentially, the more diverse your portfolio, the better equipped it may be to handle uncertainty and market fluctuations. Modern Portfolio Theory is the financial version of “don’t put all your eggs in one basket.”

According to the Modern Portfolio Theory, a well-diversified portfolio calls for 10% to 20% of one’s capital to be allocated into alternative investments, including hard real estate assets. 

According to NCREIF data compiled by Pension Real Estate Association (PREA) Research, there is a clear diversification benefit to allocating a portion of your portfolio to real estate assets. When looking at quarterly total returns spanning almost 25 years, real estate exhibited close to zero correlation to stocks. And, what’s more, real estate exhibited a slightly negative correlation to bonds. In other words, the movement in returns between real estate and stocks has little to no relationship, and real estate and bond returns move in slightly opposite directions. 

Why is this the case? According to this same research by PREA, the risk factors that underlie real estate are different from those that underlie stocks and bonds. The study found that stocks are more sensitive to risk premia (or returns expected by investors in excess of the risk-free rate as compensation for bearing additional risk) and economic growth, whereas bonds are sensitive to higher-than-expected inflation or rising short-term interest rates. Meanwhile, the primary factor that affected real estate returns was the availability of real estate loans.

In short, the value of real estate investments is not strongly correlated to the value of stocks and bonds in the public markets. Even if stock prices are declining, real estate can hold onto (or even increase) its value.

For example, 2015 was a challenging year for many investors as global markets reacted to falling oil prices and concerns of slowing growth in China. However, Harvard endowment’s annual return of 5.8% outperformed a number of other benchmark indexes, and real estate played a leading role in boosting the endowment’s overall return. Specifically, Harvard’s direct real estate investments posted the highest annual return of all portfolio asset classes at 19.4%, trouncing its second and third best-performing asset classes, U.S. equity and private equity holdings, which returned 12.4% and 11.8% respectively.

A Forbes article from October 2020 stated that individual investors have allocated only about 5% of their portfolio to alternatives, well below the suggested 10-20% called for by the Modern Portfolio Theory. “However, that percentage is likely to grow as smaller investors turn to alternative investments with a low stock market correlation - such as commercial real estate - to pursue targeted returns.” 

Asset allocation is the most fundamental strategic investment decision an investor can make. Even the experts admit that it can be the most challenging aspect of portfolio management as allocation targets will vary from investor to investor based on their financial goals.

Most individual investors don’t have the deep bench of investment resources of a major institutional entity such as pension funds or endowments. However, investors do have greater access to direct real estate investment opportunities than ever before via online real estate marketplaces. With greater access to alternative investments individual investors can more readily apply the Modern Portfolio Theory to their investment decisions and emulate a strategy employed by institutional investors. 

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