Gains from Diversifying into Real Estate: Three Decades of Portfolio Returns Based on the Dynamic Investment Model.

This paper compares the investment policies and returns for portfolios of stocks and bonds with and without up to three categories of real estate. Both a domestic and a global setting are examined, with and without the possibility of leverage. The portfolios were generated via the dynamic investment model on the basis of the empirical probability assessment approach applied to past (joint) realizations of returns, both with and without correction for smoothing in the real estate data series. Our principal findings are: 1) the gains from adding real estate on a semi-passive (equal-weighted) basis to portfolios of either U.S. or global financial assets were relatively modest; in contrast, 2) the gains from adding real estate to the universe of U.S. financial assets under an active strategy were rather large (in some cases highly statistically significant), especially for the very risk-averse strategies; 3) the gains from adding (U.S.) real estate to a universe of global financial assets under an active strategy were mixed, although generally favorable for the highly risk- averse strategies; 4) correcting for second-moment smoothing in the real estate returns series had a relatively small impact for the more risk-tolerant strategies; and 5) there was some evidence that de-smoothing resulted in improved probability estimates.