Diversification is the cornerstone of finance theory and practice. The benefit of diversification is that it helps reduce the risk of a portfolio of investments without necessarily reducing returns. The key factor determining the extent of this benefit is the correlation between the returns on the assets in the portfolio. One of the most important concepts of diversification is that assets need to be selected based on how they co-move with all other assets in the portfolio. Harry Markowitz (1959) explained this by stating, “to reduce risk it is necessary to avoid a portfolio whose securities are all highly correlated with each other. One hundred securities whose returns rise and fall in near unison afford little more protection than the uncertain return of a single security”. By taking the co-movements of assets into consideration it is possible to construct a portfolio that has the same expected return and less risk than a portfolio constructed by ignoring the interactions between assets.

Applying these basic principles to Australia’s CBD office markets provides some insightful conclusions. Table 1 shows the correlation coefficients of investment returns between Australia’s CBD office markets over the period 1984 – 2012. A coefficient of +1 indicates a perfect positive correlation, while a coefficient of -1 indicates a perfect negative correlation. The trick in portfolio construction is to simply combine assets whose return patterns are less than perfectly correlated for a given level of return.

Table 1 demonstrates that correlations between most Australian CBD office markets have been very high over the past thirty years. Sydney and Melbourne’s CBD office markets are almost perfectly correlated (0.9) as are Brisbane and Perth (0.9). The lowest correlations occur between Canberra and every other market (0.4 – 0.7), largely due to the large number of Government tenants and their resilience to the economic and financial drivers that typically influence other office markets. It is therefore suggested that with such high correlations only marginal diversification benefits can be obtained by spreading a portfolio of assets across various CBD markets.

Markowitz’s theory on portfolio optimisation seeks to assess the benefits of diversifying across assets with low or negatively correlated returns. Asset allocation decisions become less about determining the risk and return expectations at an asset specific level. As stated by Markowitz (1959), “a good portfolio is more than a long list of good stocks and bonds. It is a balanced whole, providing the investor with protections and opportunities with respect to a wide range of contingencies.” However, if high correlations exist between markets, investors in Australian office markets should focus less on portfolio decisions between markets and set out to choose a long list of good assets that meet the return target of the investor.

Table 1: Correlation matrix of Australian CBD office market returns 1984 – 2012

Source: IPD, Jones Lang LaSalle Research

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