Peter Byrne and Stephen Lee

Working Paper in Land Management and Development No. 27

October 1994 23p

The case for property has typically rested on the application of modern portfolio theory (MPT), in that property has been shown to offer increased diversification benefits within a multi asset portfolio without hurting portfolio returns especially for lower risk portfolios. However this view is based upon the use of historic, usually appraisal based, data for property. Recent research suggests strongly that such data significantly underestimates the risk characteristics of property, because appraisals explicitly or implicitly smooth out much of the real volatility in property returns.

This paper examines the portfolio diversification effects of including property in a multi-asset portfolio, using UK appraisal based (smoothed) data and several derived de-smoothed series. Having considered the effects of de-smoothing, we then consider the inclusion of a further low risk asset (cash) in order to investigate further whether property's place in a low risk portfolio is maintained.

The conclusions of this study are that the previous supposed benefits of including property have been overstated. Although property may still have a place in a 'balanced' institutional portfolio, the case for property needs to be reassessed and not be based simplistically on the application of MPT.

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