Get On The REIT Track To Sleep Well At Night

Portions of this article appeared in the Forbes Real Estate Investor

I recently finished some in-depth research comparing U.S. equity REITs with U.S. mortgage REITs and in the process, I uncovered some interesting facts.

For example, U.S. equity REITs have outperformed their closest cousins (mortgage REITs) by around 300 basis points over the past 48 years. In fact, equity REITs outperformed mortgage REITs in the 1970s, 1980s, and 1990s.

During the 2000s mortgage REITs squeaked by with a victory, but that was primarily due to an outlier year (2001) when mortgage REITs returned over 77% and then the painful losses experienced during the great recession.

So far in 2019 equity REITs have a solid lead in which the asset class has returned over 16%, compared with less than 1% for the mortgage REITs.

Now you know why I don’t waste much time covering mortgage REITs, since I prefer to invest in the winners, and I stay clear of the more volatile securities.

History has shown that a well-diversified income portfolio is an impressively low-risk plan to exponentially grow your wealth over time. This could and should feature a number of quality equity REITs.

However, there is more to dividend investing in general— and REIT investing in particular—than just selecting great companies. While many value investors are careful to only buy quality REITs at fair value or better (a wise strategy, to be sure), proper diversification is often the Achilles heel of investors. This can ultimately lead to disappointing returns and lower standards of living in retirement.

WHY DIVERSIFICATION MATTERS

Diversification is sometimes called “the only free lunch in investing.” That’s because studies have shown it increases total returns over time while reducing volatility.

In the words of Peter Lynch—the second-best investor in history, thanks to his 29% compound annual growth rate (CAGR) total returns at Fidelity’s Magellan Fund (FMAGX) from 1977 to 1990, behind only Buffett’s 20.5% CAGR total return at Berkshire Hathaway (BRK.A) over the last 54 years—“In this business, if you’re good, you’re right six times out of 10.”

So even the greatest investors of all time are frequently wrong. The reason they still deliver great returns is not by avoiding mistakes entirely, but by managing risk. They ensure that any failing investments won’t result in significant permanent losses that will stunt their portfolio’s compounding capabilities.

Even legendary blue-chips or Wall Street darlings can fail. Remember General Electric and CenturyLink? Those two former Dividend Aristocrats cut their distributions repeatedly and wiped out 75% or more of their value in the past decade.

And then there were bank stocks and REITs during the financial crisis, when dividend cuts or suspensions fell like rain during a thunderstorm.  Being overweight in such failed companies, or worse, failing sectors, can be devastating to your portfolio.

And obviously makes it much harder to meet your long-term goals, which, for most of us, means a comfortable retirement. But building a properly diversified portfolio is easier said than done. There are so many questions involved, starting with, “How many stocks should I own?” While every investor has to analyze his or her own situation, a study by the American Association of Individual Investors found:

• Holding 25 stocks reduces diversifiable risk by about 80%
• Holding 100 stocks reduces diversifiable risk by about 90%
• Holding 400 stocks reduces diversifiable risk by about 95%

As you can see, adding dozens or even hundreds more companies to your portfolio doesn’t make that big of a difference in this regard. The majority of benefits can be obtained from just 20-30 individual companies.

It’s only a matter of making sure they represent most sectors. However, as with most areas of finance, there are some important things to keep in mind. In 2014, a study was published called, “Equity Portfolio Diversification: How Many Stocks are Enough? Evidence from Five Developed Markets.”

It showed how, during times of peak market fear (i.e., corrections and bear markets), the correlation between stocks tend to rise to one. This means that even companies that typically feature low volatility, such as REITs and utilities, can fall hard and fast when facing a sea of panic selling.

ETFs and index funds certainly sell everything blindly during such times to meet withdrawal requests. To reduce diversifiable risk by 90% at least 90% of the time, the study found you should own 55 stocks during good times.

During corrections, however, you might need as many as 110. The bad news is that owning that many companies probably isn’t optimal or even possible for most people. But the good news is how that figure assumes you only own equities. There is a great way to achieve the protective—and return-boosting—effects of diversification while following much simpler risk-management rules of thumb.

Within the REIT portion of your portfolio, you should strive for a good mix of REITs representing multiple industries. In my newsletter, The Forbes Real Estate Investor, we have five model REIT portfolios with varying risk profiles.

You can lessen your risk of a single REIT industry underperforming and decrease your chances of contracting a bad case of market envy. It’s important to remember that valuation always matters.

So, don’t feel the need to buy a REIT, no matter its quality, at historically overvalued levels. All stocks tend to return to historical cash flow multiples/yields, so patiently watch-list the stocks you want. Then put your money to work at prices that will more easily deliver good future returns and higher yields.

Hopefully this helps you get on the REIT track to sleep well at night!

This post first appeared on Forbes.com. To see the original, click here.