Modern portfolio theory (MPT), developed out of Harry Markowitz’s seminal article “Portfolio Selection” first published in the Journal of Finance in 1952, holds that a risk-averse rational investor can maximize his expected return whilst minimizing risk* through a diversification of his investments holdings. This is because different types of assets often change value in opposite or less absolute ways over any given time-frame. By identifying pairs of assets that have a negative or even mildly positive correlation in their returns an investor can, by investing a portion of his worth in each of the assets, achieve a risk-adjusted return that is superior to investing in one of the assets only.
MPT also holds that an investor, to create an optimal (“efficient” in theory speak) portfolio, should consider all the various asset investment classes available to him within the investment universe. These classes include equities, bonds, and so-called “alternative” investments such as precious metals, commodities, currencies and real estate. Equities should be considered by differing sizes of investee companies (market capitalization), by region of the world (not just the investor’s home country) and by different sectors of the economy. Different types of bonds should be considered (government, corporate, convertible, etc), again by region and by size and sector. The same wide-scope philosophy should also be applied to the alternative investment categories. Studies have shown that the historical returns from investing in real estate have had a low correlation to the returns from the two major investment categories of equities and bonds.
By considering all the correlations among all the different possible pairs of investments MPT holds that an “efficient frontier” can be constructed along which additional diversification will not increase the portfolio’s expected return for a given level of risk (or alternatively no lower risk can be had for the same desired level of return). Each point along the efficient frontier will consist of a blend ofdifferent asset classes in some proportion or other. Individual investors have varying appetite for risk and consequently the asset blend in one person’s efficient portfolio will be different to that in the next person’s, as they will be at different risk points on the frontier. Once an investor has settled on an investment portfolio derived from a point on the efficient frontier he can only increase his expected return by accepting the trade-off of a higher level of risk.
Thus it can be seen that an investment in real estate (in Barbados or elsewhere) is a theoretically sound part of a wider efficient portfolio of investments.
Studies have shown that 90 percent of an investor’s return is driven by the asset allocation phase of the investment decision-making process, with the remaining 10 percent provided by the performance of the specific investments chosen within the asset categories. Thus investors should properly identify his tolerance for risk, which will be guided by his personal circumstances, goals and time horizon. This will then lead him to the construction of an efficient portfolio containing a suitable mix of asset classes within which he would select the individual holdings.
So much for the theory, what are the issues in executing a sound investment strategy as it relates to the inclusion of Barbados real estate as a part of an efficient portfolio?
Unlike the homogeneous nature of stocks, bonds and many other assets the heterogeneity of real estate means that a large outlay is needed to acquire an asset in this class. Therefore, except for the wealthiest amongst us, the concept of diversifying by region of the world and by type of property (residential, commercial, raw land, etc.) is likely an impossibility; indeed even a single property may form such a significant part of a portfolio of investments that it causes the theoretical optimal asset allocation for the real estate category to be exceeded.
Further, for many investors the volatility (= risk) of the returns from an investment in real estate is often magnified by the use of loan capital to acquire the asset. If the rate of return from the investment is less than the rate of interest paid on the loan then the overall return will have been diminished, and if greater the return will have improved.
Additionally regulatory restrictions such as a country’s exchange control regime may stymie even the most diversification-conscious investor from creating an efficient portfolio. This would certainly be true of a Barbados-based investor where the lack of a wide range of other investment opportunities within the country often leads to an overweighting in real estate by default.
What can be learnt from the above?
First, investors are not necessarily as rational and risk-averse as Harry Markowitz postulated. The growing field of Behavioral Economics has observed this time and again. There is a little bit of entrepreneur in all of us and the desire to beat the average and improve our lot burns in even the most conservative individuals. The portfolio overweighting of Barbados real estate may be a completely conscious decision of many investors: they like the emotional attachment a property can command compared to (nowadays) an impersonal electronic record of stock or bond ownership. Properties in Barbados seem to generate this kind of attachment with international investors, not least because of the country’s high worldwide profile and reputation.
Second, whilst MPT does use expected future returns as part of its process it’s use of historical observations of the correlations and volatilities of those returns (= risk) fails to account for the possibility of changes in these measurements in the future. In particular past observations have failed to hold true in times of crises, and this has been borne out once again during the recent global economic meltdown. A carefully crafted and diversified portfolio may not prove to be the elixir it promised to be, the skew towards one asset class may turn out to have been a fortunate decision.
Third, many investors regard real estate as a good store of value (studies have shown that over the long run it has been a proven hedge against inflation) and are comfortable with an overweight for this reason. In the Barbados context the recent decline in property prices, whilst undeniable, have been far more moderate than those in North America, the UK and other parts of the world (Dubai anyone?). This happy situation is due to the generally conservative lending practices of most of the lenders involved in the Barbados market, which has contributed to an avoidance of the bubble and subsequent burst experience in other markets.
In conclusion investors should always be conscious of the level of their real estate holdings within their overall investment portfolio, be comfortable with that level, be aware of the overweight that a substantial investment in even one property may imply for their theoretical optimal portfolio, be knowledgeable of the potential outcomes of borrowing to finance a property acquisition, and be willing and able to accept both the potential upsides and downsides of all such situations.
* Risk is measured by observing the volatility of the returns from an investment over time. Those investments with the larger variations (most volatile) from the average return are considered the riskier.
Prepared for Terra Caribbean’s The Red Book 2010 Pink Pages by Simon Milligan, CFA FCA Independent Financial Consultant