There are tons of informative, well-written articles on individual stocks, bonds, and REITs for investors to consider adding to their portfolios. Too often, however, these articles are written in isolation, without any guidance or suggestions to the reader on how to invest in these securities. We hope that you aren’t investing 100% of your assets into a stock you just read a positive article on. But how much should you be investing in each stock you read about and how many positions should you have in your portfolio? In particular, how should you use REITs in your portfolio?

Before we get into how to use REITs in your portfolio, let’s first analyze the different investment objectives inherent in each portfolio:

Wealth Preservation

Income

Growth

Typically, the younger you are, the more likely your portfolio will be oriented towards growth. This makes sense ,considering the majority of your income earning years are still ahead of you and you can afford to withstand the short-term volatility of growth-oriented investments in exchange for a higher long-term return potential. On the other hand, as you reach the end of your working years, your portfolio should approach a preservation objective because frankly, you don’t want to lose what you have accumulated. And finally, when your income from earnings decrease or disappear due to retirement, you rely on your portfolio for income.

This is not to say that a portfolio only has one of these objectives at one time, but rather, depending on each investor’s unique situation, there will always be some combination of some or all of these objectives. There are also other factors to consider for an investment strategy, such as risk tolerance, short-term liquidity needs, taxes, etc. but these are constraints that must be considered while trying to achieve one or all of the objectives mentioned above.

Asset Classes

So once you have your investment objectives defined and understand the constraints to achieve those objectives, you must then consider which investments to pursue that will increase the likelihood of reaching those goals. Each asset class has unique characteristics that make it useful for achieving one or more of the objectives mentioned above, but typically not all three at the same time.

For example, growth of capital is usually achieved through investments in equities, and the higher growth potential in the long term can come from small cap equities or emerging market equities. While they can be more volatile in the short-term, they tend to outperform the wealth preservation and income generating investments over the long-term. Large cap equities, on the other hand, can provide some upside growth, but can also generate income if it is a dividend paying stock. So, dividend paying stocks may have the ability to contribute to two of the investment objectives.

If you are looking for income, the traditional asset class used is fixed income, through investments in sovereign or corporate bonds. Within this asset class, the higher the credit rating and shorter the maturity (duration), the greater the shift of these assets towards achieving the wealth preservation objective. Investments in high yield or longer maturity (duration) bonds may provide more income, but can fall short on wealth preservation.

The spectrum of asset classes from wealth preservation to growth could be viewed in the diagram below. Keep in mind that some investments should actually be placed inside the triangle because they have characteristics contributing to all three objectives. But for simplicity and for ease of observation, they have been placed along the outside.

Asset Allocation

Finally, the last concept we want to mention is that of asset allocation. Too often, we see individual investors buying individual securities with little consideration for the overall asset allocation. This missing the forest through the trees approach oftentimes results in a portfolio that is overweight to certain asset classes or sectors within an asset class and exposes you to unrealized risks. So we always propose an asset allocation strategy to be implemented from the top-down, not from the bottom up. In other words, decide how much of your portfolio should be allocated to wealth preservation, income, and growth, and stick to those allocations. Looking at it another way, you can decide how much to invest in equities versus fixed income versus any other asset class and make sure to adhere to those allocations, save for a few tactical plays when opportunities arise.

Diversification

You should also be cognizant of the diversification in your portfolio. While it’s nice to put a heavy weight into an investment that worked, you don’t want to have all your eggs in one basket when things go wrong. Limiting position size to a reasonable level can help you preserve what you have, so you can reinvest it tomorrow if things don’t go well with certain investments. Each individual investor has to decide how much diversification is appropriate for his/her own portfolio so we won’t get into that here.

REITs

So this brings us to the question of how to use REITs in your portfolio. If you have invested in REITs in the past, you probably realized that some REITs behave more like equities while other types of REITs behave more like bonds.

One approach is to give them their own classification under alternatives, or real estate, or something else, but not equity or fixed income. Our approach to REITs is consistent with the three objectives we mentioned earlier. Some REITs are better suited for wealth preservation, while others are consistent with a growth or income approach.

For example, just to use a simple comparison, we can compare a residential property REIT, in this case Equity Residential (NYSE:EQR ), which invests in multi-unit housing, to Annaly Capital Management (NYSE:NLY ), which is a mortgage REIT that invests in mortgage backed securities.

If you look at the performance of these two REITs since 5/2008, which is shown in the table below, you will notice that EQR experienced price appreciation of 43%, while NLY actually dropped in price by 3%. But comparing the total return of these two REITs including dividends paid and assumed to be reinvested, EQR had a total return of 71% over the same period, while NLY had a return of 80%. (Another mREIT, American Capital Agency Corp (NASDAQ:AGNC ), had price appreciation of 77% and a total return of 300%. We point this out because the comparison of an mREIT to a bond is not perfect and the potential for price changes does exist, as evidenced by AGNC)

This simple analysis leads us to think that EQR behaves more like a dividend paying stock (and the yield is comparable to a large cap dividend paying stock), while Annaly has the characteristics of a high yield bond purchased at par. (Different from a high yield bond purchased at a discount, which can also lead to substantial price appreciation.)

If we had to add REITs to the spectrum diagram shown earlier, we would draw it as follows:

We drew some of them within the triangle to show our earlier point that some of these asset classes have characteristics that may contribute to all three objectives. The diagram is not perfect either, just meant to make a point.

So with a better understanding of the behavior of a variety of REITs, you can better plan on how to add these to your portfolios to reach the goals you have set out.

First of all, we think that a combination of REITs within a portfolio will provide a better risk-adjusted return to your overall portfolio. Despite the common mistake of grouping them all together, as you can see from the correlation matrix below, many REITs actually have negative correlation to each other. The dark green indicates a negative correlation for the REITs intersecting at that point. We made them green because combining assets with negative correlation is good for portfolio diversification. The red boxes indicate positive correlation and indicates that the combination of the two REITs will not provide much as much diversification to a portfolio.

To clarify, correlation is a measure of how certain securities move in tandem. A correlation of +1 indicates that two securities move in sync, while a correlation of -1 indicates that the two securities move in exactly the opposite direction (this would result in ideal diversification). A correlation of 0 indicates absolutely no relationship between the two securities. In other words, they move randomly relative to each other. And of course, every other measure in between is just relative. If you look at the intersection of SPG and BXP, you will see a correlation of 0.94. That means they move very closely to each other, while WY and AGNC have a negative 0.49 correlation; this makes sense, since WY is a timber REIT and AGNC is an mREIT. Notice that the mREITs (AGNC, ARR, and NLY) have negative correlation with the other REITs. So combining them with other REITs will be beneficial to your portfolio.

The idea I am proposing is to use REITs within the three investment objectives mentioned above, along with the more traditional asset classes.

If you are looking for investments to preserve capital/wealth, I would suggest using a defensive REIT in addition to highly rated, shorter maturity bonds. An example would be to use HCP Inc (NYSE:HCP ) which has a beta of 0.7 to the S&P 500 and one of the lowest standard deviations of the equity REITs. It is also a player in the healthcare sector, which is a highly defensive sector.

Within the income component of your portfolio, you should consider some of the mortgage REITs, such as Annaly, American Capital Agency Corp, or ARMOUR Residential REIT Inc (NYSE:ARR ), to name a few. These types of REITs can complement any of your current holdings in high yield or emerging market bonds.

Finally, there is the growth objective of your portfolio. This one could be a bit tricky because if you looked at the return table above, you may have noticed that AGNC had a return of 300% over the last 4 years. But these returns are not typical of mREITS, but rather, a result of a very beneficial environment for these types of investments. For the growth component of your portfolio, I would lean more towards REITs with price appreciation potential, such as Simon Property Group (NYSE:SPG ), Equity Residential. and even Weyerhaeser (NYSE:WY ). These types of REITs should complement your holdings of high quality dividend paying stocks, which also provide modest income, with upside price potential.

By applying these concepts to your portfolio, maintaining discipline, and monitoring your portfolio on a regular basis, I think you will be happy with the results that the addition of REITs will provide. In addition, the REITs mentioned in this article can all be combined to perform well in any economic environment.

Disclosure: I am long AGNC. ARR. NLY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.