Diversification of portfolio risk: reconciling theory and observed weightings

During the 1990s and early 2000s an international body of literature explored property portfolio diversification strategies, motivated by the view that reliance on administrative regions to represent asset classes is suboptimum because they are based on historic and governmental factors rather than market fundamentals. Thus, individual 'asset classes' may contain highly heterogeneous areas, violating the basic tenets of investment theory. Asset classes based on alternative market groupings were proposed and are re-evaluated here. A sample of 73 local markets is analysed covering 1998--2007, with temporal stability additionally explored. Comparative portfolio performance opportunities are assessed using efficient frontiers, with the alternative market groupings most often found to offer superior performance to traditional strategies. Further than this, the optimal weightings suggested by the classifications are compared to observed aggregate institutional investment weightings. The differences in allocation are found to be considerable. Subsequent hypothetical benchmark portfolios, constructed using observed allocations, are found to statistically significantly violate the mean variance criterion in volatile market phases. Explanations are proposed, drawing on the investment characteristics of property and consequences for portfolio management, as well as an exploration of behavioural factors to include benchmarking. A re-visiting of investment theory and practical strategies is urged.