The Basis Of Investment Property Wealth Management: A Modern Portfolio Theory Explanation

The Basis Of Investment Property Wealth Management: A Modern Portfolio Theory Explanation

Posted by on May 27, 2020

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The goal of the Investment Property Wealth Management™ program is to move direct real estate owners into wealth managers. This is done by placing “hard” assets into professionally-managed portfolios, then offering owners the opportunity to invest in these portfolios. The strategy behind these portfolios is based on a concept known as modern portfolio theory

With help from modern portfolio theory, IPWM™ professionals have the capability to consistently rebalance portfolio performance, which can lead to reduced risk, predictable income and wealth preservation.

Modern Portfolio Theory — Explained

Before continuing, it’s a good idea to understand the thinking behind modern portfolio theory. Frequently abbreviated as MPT, modern portfolio theory introduces three concepts.

  • The potential returns of an investment are directly tied to the level of risk involved. In other words, the higher the risk, the higher the level of return.
  • A portfolio’s overall risk/return profile is more important than the risk/return profile of a single investment.
  • Creating a diversified portfolio, consisting of multiple, non-correlated assets, can limit an investor’s risk, while maximizing returns.

The concept of portfolio risk diversification wasn’t widely known or understood when economist Harry Markowitz published his article, “Portfolio Selection,” in the early 1950s. At the time, the accepted investment principle was that stocks and other assets should be researched and examined individually, in an effort to find “winners;” those securities that produced positive returns with minimal risk.  

Markowitz, however, downplayed the “singular” approach, pointing out, instead, that an investor was far better off with a portfolio of diverse, non-correlated stocks and assets, which would better balance risk and reward. 

His initial article didn’t make specific mention of modern portfolio theory — that terminology would come latter — but it did list a series of mathematical equations outlining the benefits of portfolio-wide stock-and-bond diversification. Because of this and his other writings on portfolio allocations, Markowitz is widely known as the “father” of modern portfolio theory, for which he eventually won a Nobel Prize. 

These days, MPT is a highly effective tool to help investors achieve a stronger portfolio risk/reward balance.

MPT and  IPWM™

While MPT is useful for securities portfolios, it hasn’t been used much to balance risk and reward among direct real estate investments. However, the IPWM™ program relies on the same MPT principles used with successful stock and bond portfolios, using the following.

Asset allocation. IPWM™ professionals buy and sell real estate assets that balance a portfolio’s risk, while seeking predictable and regular cash flow to investors. Asset allocation helps ensure that risk and reward are balanced in accordance with an investor’s risk tolerance, time frame and goals.

Diversification. Capital is spread across different types of real estate assets, leading to risk management for the investor. Individual asset classes are balanced, creating a portfolio focused on an investor’s goals and income needs.

Inter-asset optimization and non-correlation of assets. We believe that MPT is an ideal tool for real estate portfolios, as each asset is unique, leading to minimal correlation. Correlation is defined as the degree to which assets’ values increase or decrease in relationship to each other. An apartment complex in Atlanta, GA isn’t going to be directly correlated to a net-lease retail property in Dallas, TX. A reduction in correlation helps maintain a portfolio’s value, while managing risk and potentially increasing returns.

From Theory to Reality

Since the mid-20th century, modern portfolio theory has been successfully used to help investors balance risk and reward when it comes to securities portfolios. The move from individual analysis of single investments to an emphasis on entire portfolios has helped these investors balance risks during economic expansions and contractions.

MPT can be effectively used when it comes to real estate, as well. IPWM™ is taking the same principles introduced by Markowitz, and effectively using them to convert real estate owners into wealth managers. In the next chapters, we’ll go into more detail about diversification, risk and wealth preservation.

 


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