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How REITs Can Benefit a Diversified Portfolio

If you own a house, and your home equity represents a hefty portion of your total assets, you may not want or need any more investments in real estate. But if you’re trying flesh out your portfolio with some real estate exposure—without the hassle of becoming a landlord—one way to achieve it is through real estate investment trusts.

Better known as REITs, these securities invest in real estate and often trade on major exchanges, just like stocks. There are two main types of REIT: one invests in mortgages, which as you can imagine, tend to be highly correlated with bonds. The other invests in actual real estate properties, usually commercial real estate. As it turns out, many investors use property REITs to diversify their portfolios because REITs tend to not correlate strongly with other asset classes.

What is Correlation and Why Should You Care?

Many asset types tend to move together in a similar direction, even if not the same amounts. For example, large cap U.S. stocks tend to rise or fall at the same time as small cap U.S. stocks. This isn’t surprising since both tend to benefit, or be challenged, by economic conditions in the United States.

This is called correlation. The more closely any two asset classes move together, the higher the correlation. Correlation can be either positive or negative. An investment that declines in value while its counterpart increases in value would be negatively correlated.

You need to know this because the value of diversification comes from having a collection of assets that don’t all move in the same direction in response to the same market conditions. A high level of correlation can make your portfolio unacceptably volatile, while holding uncorrelated or negatively correlated assets may help keep your portfolio on a more even keel during turbulent markets.

REITs don’t correlate strongly with other assets for two key reasons. First, pricing in the real estate markets moves much slower than in the stock markets. While the Dow might rise or fall several percentage points in a day, it is a rare occurrence that would make an office building suddenly worth five percent more or less than yesterday. Secondly, while capital gains are important to REITs, a great deal of their value actually comes from the ongoing collection of rents on the property. Such income is not tied to the markets at all.

So by adding REITs to a stock portfolio, investors may find a low-correlated asset to help improve overall diversification. One way to invest in REITs is through Folio’s REIT RTGs. Investors can choose from 4 different ready-made REIT folios providing broad exposure to a choice of residential, retail, industrial-office, or large REITs. As always, it’s important to remain mindful of the risks inherent in all investments, and to remember that past performance is no guarantee of future results.

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