Historically low correlations (see matrix below) among real estate investment trusts (REITs) and other asset classes would suggest that they have potential diversification benefits within a globally diversified portfolio. Although REITs have generally been more volatile than stocks in the past, including a separate allocation to them would have actually helped to reduce the risk of your overall portfolio.
Correlation Matrix: January 1998–December 2011
Sources: Dimensional Fund Advisors, Morningstar EnCorr
As with any discussion about asset allocation, the optimal amount of REITs to include in a portfolio is more art than science – there is no hard and fast rule. Here is what some industry experts have suggested in the past:
I would generally consider starting with 10% of your stock allocation; whatever your portfolio allocation to stocks, carve out 10% from that amount and allocate this portion to Canadian, U.S., and International REITs. In the example below, I’ve taken the historical returns of a typical balanced “Couch Potato” portfolio (Portfolio 1: 40% bonds, 60% stocks) and carved out 10% of the stock allocation (or 6%) and allocated it evenly between three REIT indices (Portfolio 2: 40% bonds, 6% REITs, 54% stocks).
With a modest addition of REITs to the portfolio, the overall return actually increased (5.4% versus 5.2%) while the standard deviation decreased (8.0% versus 8.2%).
If you decide to include REITs as a separate asset class in your overall portfolio, understand that there may be lengthy periods when REITs will underperform the broad stock market; it is at these times that you will need to avoid any knee-jerk reactions and stick to your original investment plan.