This webinar outlined how risk is reduced when assets are combined in a portfolio. This included an introduction to modern portfolio theory and how it is applied to the unique challenges present in commercial real estate.

Implementing Strategy

The topic on asset allocation is a continuation of a webinar series dedicated to explaining how to deliver a client’s investment objective. As Malcolm explains, asset allocation is one of our four means of delivering our investment objective. The fundamentals of asset allocation were laid out in the 1950s by Harry Markowitz in what is known as Modern Portfolio Theory.

Modern Portfolio Theory

A central tenet of MPT is the assumption that investors are risk-averse. This relates to the client’s investment risk and return objectives. That is, maximizing return for a given level of risk (or minimizing risk for a given level of return). The three inputs within MPT are the expected return, risk, and correlation. Malcolm explains that the interrelation between the three factors is that if returns are less than perfectly correlated, then a portfolio can generate a higher return per unit of risk through diversification.

The magic in MPT is that Markowitz demonstrated that, by taking a portfolio as its whole, it was less volatile than the total sum of its parts. Markowitz argued that portfolios should optimize expected return relative to volatility. He considered volatility could be measured as the variance of return. He also suggested a limit he called the “efficient frontier. Malcolm explains that the efficient frontier is a graphical display of a set of portfolios that maximizes expected returns for each level of risk (standard deviation).

Thus, as an investment manager, your job would be to model the efficient frontier. Next, devise a segmentation of the market that minimizes the variation within categories but maximizes the variation between categories. Finally, you should model forward-looking returns based on current pricing and expected future growth. For example, thinking about the current market, there have been some very significant hits to retail because of the move to online retailing. Thus, one would not expect the same return pattern going forward, as we’ve seen in the past. To populate your model, you will need to project future returns. You can start off using the historical returns and adjust for what you expect the future growth outlook to be.


Author: Khathutshelo Nematswerani