Good investment literature always recommends diversification. It counsels investors to forget about trying to pick the next Apple or Microsoft. That is a guessing game, and the odds are against small investors. Here at Later Living, I have followed the literature and used example portfolios consisting of broadly diversified stock and bond index funds. Today I will include real estate, or REITs, in the retirement portfolio.
REITs are real estate investment trusts, and they owe their modern form to legislation enacted in 1960 and subsequently modified. REITs provide investors easy ways to participate in investments like apartments, office buildings, shopping centers, timberland, and others types of income-producing real estate.
Investors often think of their homes as investments. Personal homes don’t usually produce cash rental income, and they are a particular size and condition, and in a particular location. REITs may own many commercial properties in many locations, offering diversification and regular income.
Investors may buy shares of individual REITs on stock exchanges, they may buy actively managed mutual funds that hold REIT stock, and they may buy high quality REIT index funds that track broad indices of REIT performance.
Portfolio Returns With REITs Included
In previous posts, I have stressed the importance of prudent, temperate management of investment portfolios in later life. When a portfolio must support someone for 30 years or more through regular withdrawals, retirees must avoid large mistakes that may leave a retiree impoverished.
Still, it is possible to be prudent and uncomplicated in managing investments. In February I presented a six-step approach to managing investments during retirement, showed that the approach worked with well-known stock and bond funds, and that broader diversification among stocks and bonds helped improve performance.
The six steps involve withdrawing an initial 4% from a balanced portfolio of stocks and bonds and rebalancing each year to preserve a constant proportion of stocks and bonds. The model used the Vanguard Total Stock Market Index Fund Investor Shares, and the Vanguard Total Bond Market Index Fund Investor Shares.
REITs can be incorporated in a similar way by using the Vanguard REIT Index Fund Investor Shares. Vanguard is a reputable, low-cost provider of mutual funds, and I receive no compensation or other benefit from using these example investments.
The table below shows the annual portfolio values for the most recent 11-year period, starting with $100 in 2001 and ending at the close of 2011. At the beginning, a $100 portfolio consists of $42.50 in stocks and bonds, and $15 in the REIT. Academic and professional investment advisors often recommend that 10% to 20% of a portfolio be invested in real estate, and today’s example uses 15%. The remaining value is split evenly between stocks and bonds. Columns two, four, and six show the annual returns to the three investments from 2001 through 2011.
Columns three, five, and seven show year-end values for stocks, bonds, and REITs. The last two columns show the portfolio value at year-end and after the withdrawal for living expenses, which is set at $4, or 4% of the initial portfolio value.
As everyone seems to know, the most recent 11-year period cast investors into the winds of great storms. There was the collapse of stock market values in the early part of the period as the Internet bubble burst, then a few years of relative calm until the real estate fiasco engulfed the world economy. These storms are reflected in the returns in the table—there are years of severe downdrafts in various investments.
Yet a balanced collection of only three mutual funds run by a reputable, low cost provider, ended the period 23% higher than it started, even while supporting annual withdrawals of 4% of initial value. Given the rhetoric surrounding the past 11 years, these results may surprise readers. Nonetheless they are true.
Simplicity is a popular theme in modern life, and it can be a theme for investments as well. The six-step model with the three mutual funds used here is a simple approach to retirement investment, one that most retirees with portfolios can no doubt master. Of course, it is not a guarantee to success—no one can know the future with certainty.
But three broadly based index funds, with low costs, diversified across major types of investments, and held in a reasonably consistent balance over time, gave good results through one of the most turbulent periods of modern investment history. That is good news.