Reducing Risk While Simultaneously Increasing Potential ReturnJuly 12, 2019
Investing involves taking calculated risks in exchange for expected returns. The challenge for investors is to accurately identify risks and potential rewards from various assets and assemble them into a portfolio that at least meets their investment objectives.
The trade off between expected risk and return
Theoretically, expected returns are supposed to be highly correlated to the level of investment risk inherent in the underlying asset. In other words, all other things being equal, an investor would have to be willing to increase the risk level of their overall portfolio in order to increase potential returns. But, what if there was an asset class that actually allowed an investor to reduce the overall volatility of their portfolio while simultaneously increasing its potential return?
When constructing portfolios, investors must balance two competing goals: maximizing portfolio returns and minimizing portfolio volatility. Tools such as the Sharpe ratio can help investors compare projected return with expected risk across asset classes and portfolios. The Sharpe ratio is widely accepted as the best measure of how successfully an investment portfolio balances those goals. Specifically, the Sharpe ratio measures whether higher returns are enough to compensate for an increase in portfolio volatility, and, conversely, whether lower volatility is enough to compensate for a decrease in portfolio returns. From a practical standpoint, this means that adding an asset class to your portfolio that has a higher Sharpe ratio than the other assets in your portfolio should reduce the overall volatility of your portfolio while simultaneously increasing its potential return.
Canadian private multi-residential real estate
Exhibit 1 clearly shows that over the 16-year period ending in 2018, the Sharpe ratio, and, therefore, the risk-adjusted return for Canadian Private Multi-Residential Real Estate was meaningfully higher than for Canadian Bonds, as well as Canadian, U.S., Global, Emerging Market Equities and Canadian Public REITs, which are the most common components of almost every investor portfolio.
Another way to look at risk is from the down-side protection aspect. Over the last 16 years, Canadian Private Multi-Residential Real Estate has provided investors with significantly better downside protection. From 2002 to the end of 2018, multi-residential properties have never had a negative annual return. In contrast, Canadian Public REITs, Canadian Bonds, Canadian Equities, U.S. Equities, Global Equities and Emerging Market Equities had negative annual returns 13% to 25% of the times, (Exhibit 1).
To further illustrate the potential downside protection inherent in private multi-residential real estate, let’s take a look at Graph 1, which isolates the 2008 financial crisis and the returns achieved by various asset classes during this time.
Graph 1 shows that during the 2008 financial crisis, Canadian Equities fell by approximately 31%, Canadian Public REITs fell by 38%, and U.S. Equities by 23% (in Canadian dollar terms), while the 2008 annual return for Canadian private multi-residential real estate was a positive 6.5%.
In today’s constantly agitated market, which appears to often be driven by disruptive tweets and volatile machine trading that is based purely on social media key words, maybe it’s time to start sheltering some of your portfolio in very defensive private multi-residential real estate, which also just happens to provide significantly higher risk-adjusted returns than both low-yielding Canadian bond and volatile equities.