Measuring the Effectiveness of Geographical Diversification

Abstract

Executive Summary. How many markets does it take to form a geographically well-diversified portfolio? Using a simulated approach, this study investigates the effectiveness of geographic diversification across the metropolitan areas in the United States. Four diversification schemes, the “Mixed MSA,” “Large MSA Only,” “Simultaneous,” and “Large MSA by Property Type,” are analyzed. The effectiveness of diversification is measured by the proportional portfolio risk reduction from the risk of single market. The findings suggest that: (1) it takes a large number of markets to eliminate most of nonsystematic risk in portfolios; (2) diversifying across large MSAs only is much less effective than across all MSAs; and (3) different types of properties exhibit very different risk reduction capability. The study raises the question as to how well-diversified are current institutional portfolios.

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