| Extreme price volatility experienced in equity trading markets in the 21st century has re-emphasized the importance of diversifying portfolios of investments underlying the U.S. market-economy. There are, however, two problems identified with practices of diversifying investments common to a U.S. equity trading market. First, there are known limitations with modern portfolio theory (MPT). While Markowitz's (1952) mean-variance (MV) theory has served as the foundation for MPT and model for diversification for 50 years, the use of MV assumes investment returns are normally distributed. This assumption conflicts with observed behavior supporting the existence of non-normal distributions (Bond and Patel, 2000). The second problem identified is the effects of globalization continue to abate opportunities for diversify systematic risk of investments common to a single market-economy.; Evidence is provided that real estate as an asset class provides diversification benefits to mixed-asset investment portfolios (Mueller, Pauley, and Morrill, 1994). This study compares the effectiveness of real estate, represented by NAREIT Equity REITs, to diversify systematic risk of a U.S. equity market, represented by Standard & Poor's 500 Index, relative to investments in the bond asset class and different market-economies.; Four methods of diversification are used with this study including MV, where risk is measured by standard deviation, and the lower-partial moment (LPM) approach, where risk is measured by semi-deviation, and two newly developed methods. One newly developed method is the bi-variate efficiency-ratio (BER), where returns below a benchmark return are minimized as the “expected loss”, measured by the expected value of the LPM and returns above the benchmark are maximized as the “expected gain”, measured by the expected value of upper-partial moment. The other method developed is the co-variate efficiency-ratio (CER), a replacement to the use of the correlation coefficient, intended for use when risk is measured by the LPM to determine diversification benefits between investments. As alternative to the correlation coefficient, the CER introduces the concept of the “cost” to derive the “benefit” of diversification, where the “net-benefit” is measured by the tendency of returns between investments to vary in opposition and tandem to each other when above and below the benchmark return. |
