Optimal Portfolio Allocation among REITs, Stocks, and Long-Term Bonds: An Empirical Analysis of US Financial Markets

Abstract

Using mean-variance utility function analysis with various degrees of risk aversion, this research examines the impact of Real Estate Investment Trusts (REITs) in creating optimal portfolios. It also examines and develops a sensitivity analysis for differential risk premiums in REIT stocks and the effect in determining an optimal portfolio mix by applying mean variance analysis. When the combined risk premium of REITs and stocks is 1.5%, we find investors with risk aversion between 1 and 6 are better off investing almost entirely in REITs, short selling the bond and investing very little in stocks. Investors can benefit in the same way even when the risk premium of REITs and stock is fixed at 2.0% with risk aversion equal to between 1 and 9. However, when the risk premium of REITs and stock is fixed at 2.5%, the investor's risk aversion factor is irrelevant, and it suggests investors should short sell the bond and invest mostly in REITs. The marginal effect of changes in (portfolio returns) rR on the optimal portfolio weights in REITs is observed to have a sharp decline when risk aversion is increased. However, the impact of that change in the REIT-Stock correlation is non-existent as the optimal weight in REITs is increased. In addition, there is little obvious change when the risk aversion is increased. Therefore, the change of weights in REITs in the optimal portfolio is more significant than the correlation between REITs and stock performance. Results also indicate that the investor should consider how to maximize their return using various levels of risk aversion and not by using the correlation between stock and REITs.

Using investor utility to determine portfolio choice with REITs

“…The portfolio diversity stems from the varying risk preference among investors. Studies such as Waggle and Agrrawal (2006), Moon (2006), andBhuyan et al (2014) introduce risk preferences in the decision process. They assume the utility function U ¼ m -0.5u s 2 , where m is the portfolio return, s is the portfolio return standard deviation, and u is the risk preference.…”

REITs impact on typical investment portfolio – further evidence of the sector split importance

“…Further, Lee (2010) concludes that the overall benefits of the inclusion of REITs in a portfolio depends both on the time frame and on individual portfolio constituents (asset classes). Bhuyan et al (2014) measured the impact of REITs on the optimal mixed-asset portfolio creation for investors with various degrees of risk-aversion, using a meanvariance utility function framework. Their findings suggest, among other things, that risk-averse investors should invest in REITs at the expense of bonds, and that the marginal effect of REIT returns on their optimal portfolio weights increases with risk tolerance.…”

Performance Analysis of a Philippine REIT and Its Optimal Allocation in a Mixed-asset Portfolio

“…This, in turn, would give new suggestions for the optimal AREIT weight, which is dependent on the riskaversion level. For this study, we follow the convention used by Bhuyan et al (2014) of using risk levels 1-10 for ease of interpretation. Thus, we focus on the behavior of the AREIT throughout the risk-aversion levels to capture the general trend or change in AREIT weight.…”

“…It becomes difficult to choose an optimal portfolio when returns increase with risk. Bhuyan et al (2014), thus, incorporated the utility theory into the analysis to take into account an investor's risk aversion. This study aims to determine the behavior and performance of the first Philippine REIT and then apply these findings in constructing a mixed-asset portfolio.…”