Thursday, September 28, 2006
That Abominable Four-Letter Word
Risk aversion and risk tolerance in real estate investing.
There is no such thing as a ‘riskless' investment, certainly not in real estate. And if there was, common sense dictates that it would not offer sufficient return to justify its existence. Risk and reward are closely linked. For the most part, the higher the perceived risk of an investment, the higher its potential reward. Therefore, attempting to eliminate, or even to reduce risk dramatically, may not be an investor's most optimized strategy.
Harry Max Markowitz, the 1990 Nobel Prize winner in Economic Sciences and Professor Emeritus at City University of New York pioneered significant breakthroughs in the correlation between risk and diversification, and between relative and absolute risk aversion and risk tolerance in finance utility, the principles of which were later on used to the postulate Risk Theory and the Modern Portfolio Theory in financial economics.
In simplistic terms, Prof. Markowitz wanted to go beyond the traditional ‘don't put all your eggs in one basket' axiomatic line to managing investments. His approach was to define how can an investor earn attractive returns without undue amounts of risk and, conversely, establish how much risk input is necessary to achieve a certain investment goal.
Risk aversion is a concept that attempts to explain the behaviour of consumers and investors under conditions of uncertainty. More specifically, risk aversion is the reluctance of a person to accept a bargain with an uncertain payoff, rather than another bargain with a more certain but possibly lower expected payoff. The inverse of a person's risk aversion is called risk tolerance. Using this model, Prof. Markowitz discovered that it is possible to simultaneously minimize risk and improve returns by having a broadly diversified portfolio. The efficiency optimization of this portfolio is known as the Markowitz Efficient Portfolio, where no additional expected return can be gained without increasing the risk of the portfolio (or, alternatively, where no added diversification can lower the portfolio risk for a given return). In practical terms, the Markowitz Efficient Portfolio finds the optimal equilibrium between risk and reward.
In essence, the thrust of Modern Portfolio Theory has been to shift from trying to maximize returns to managing risk. Unfortunately, a great many real estate investors spend their time doing exactly the opposite. The lure of a single high-yield investment is tempting and capturing but, all other variables being constant, many fractional smaller investments add up to the same yield over the same capital investment with a much lower degree of risk.
Take the case, for example, of three investors - Investor A, Investor B and Investor C - who are each about to purchase two million dollar worth of real estate properties. Investor A purchases a 2-million dollar rental building yielding an 8 percent CAP rate. Investor B purchases eight residential rental units worth an average of $250,000 apiece, yielding an aggregate 8 percent return. Investor C purchases a two million dollar worth combination of residential, commercial and industrial products, yielding an aggregate combined total 8 percent return. Prof. Markowitz' theory can detail out, as a mathematical function, that the risk-return profile of Investor C's portfolio is the most optimized and, moreover, that it displays the lowest possible level of risk for its level of return. This is obtained by measuring risk as the standard deviation of the return on investment, that is the level of uncertainty of the return.
The relevance of Prof. Markowitz' work to the discipline of real estate investments is to be found in the underlying movements of Market Risk. Market Risk is the stress that the value of an investment will undergo due to moves in market factors. Market Risk is of very real importance in times of price reductions, such as the present. The three standard risk factors that apply to real estate investments are:
[ ] Equity Risk, or the inverse of the risk that prices will change.
[ ] Interest Rate Risk, or the risk that interest rates will change.
[ ] Volatility Risk, or the risk that the speculation component will change.
Market economic shifts are caused by two, and only two factors: a shift in the Interest Rate component of risk or a shift in the Volatility Risk. For instance, these days it would appear that Volatility is the primary factor in the slow-down of real estate markets, due to lower speculation which is causing a upward shift in Equity Risk (the lower the prices, the higher the risk) through lower demand, which in turn generates an inventory surplus. Interest Rate Risk, though certainly a contributing factor, is of secondary importance, as the Fed has been very cautious to allow ample time for the economy to adjust between increases.
Contrary to the belief of many, risk allocation has nothing at all to do with market timing. In fact, all empirical evidence suggests that market timing is more pipe-dream than reality. By definition, market timing means buying low and selling high, and we all know that this is the key to successful investing. So, in theory, market timing is logical. Regrettably, however, there is no guaranteed way to anticipate market movements, so most attempts at market timing fail to deliver the results investors hope for.
Risk Theory and the work of Prof. Markowitz are of utmost importance in the two main financial disciplines of Capitalism: real estate and the stock market. But they also find their place in more exotic fields of application. For instance, when combined with probability calculus in Applied Mathematics, Risk Theory is used by casinos or lottery institutions to optimize (reduce) the risk of payout (a.k.a. the ‘odds' of winning), which goes to explain why one always loses. Likewise, governments use the Markowitz-curve to set taxation policy. Capital gains tax deferments, both allowed by the Internal Revenue Service in the States and by the Canadian Customs and Revenue Agency, are predicated on the basis of Risk Theory. And large industrial conglomerates, such as the Big Three or even Hollywood, use Prof. Markowitz' work to determine the risk of launching a new product, that is to anticipate with reasonable accuracy whether a new product will be a hit (risk tolerance of the output at decreased uncertainty) or a flop (risk aversion of the output at increased uncertainty).
Although, in the case of Hollywood, it might be argued that when applied to the ‘Da Vinci Code' , Risk Theory did not deliver very accurate results - Oops ...
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