A reader writes in, asking:

“I noticed that you no longer include REITs in your portfolio. [Mike’s note: See here for the post explaining the portfolio change he’s discussing.] Do you feel that you’re giving up some degree of diversification? And, for those of us who do include REITs, how would you suggest we count them toward an overall stock/bond allocation?”

I liked this question because it gives us a chance to address a couple common misconceptions about REITs.

What is a REIT?

Real estate investment trusts (REITs) are companies that invest in real estate — sometimes commercial real estate, sometimes residential estate, sometimes both.

REITs are unique because of the way they’re taxed. Specifically, they are not subject to corporate income tax, provided that they satisfy a few requirements. For example, REITs must distribute at least 90% of their taxable income to shareholders every year.

Should REITs Be Counted as Stocks or Bonds?

Despite their unique tax treatment and their high yield, shares of ownership in a REIT are still, by definition, equity investments. In other words, when considering your overall stock/bond allocation, a REIT fund should be counted as a stock fund because it is a stock fund — a sector-specific one, much like a health care fund, for example.

REITs Are Included in Total Market Funds

While my portfolio does not include a REIT-specific fund, it does still include REITs. REITs are included in broad “total stock market” index funds in proportion to their market weight — just like stocks from every other market sector.

REITs are included in many other stock index funds as well. For instance, as of last year, the S&P 500 included 15 different REITs.

REITs as a Diversifier

Because of their high-yield characteristic and because of the fact that REITs are often more closely correlated to real estate prices than to the stock market, REITs are often thought to be a good diversifier for a typical stock portfolio — the idea being to overweight them relative to their market weight in the hope of reducing overall portfolio volatility.

Personally, I’ve found the “REITs as a diversifier” argument (just barely*) convincing enough to include a REIT fund in the index fund portfolio my wife and I were using until recently. That said, having now moved to an all-in-one LifeStrategy fund that does not overweight REITs, I’m not worried that we’re missing out in any way that’s likely to meaningfully impact our long-term success as investors.

*It’s useful to remember that imperfect correlation doesn’t in itself make something a useful diversifier — otherwise you could take a total stock market index fund and overweight any stock in it (on the basis that each individual stock has an imperfect correlation to the rest of the portfolio) and thereby reduce the portfolio’s volatility.