by Archie M. Richards, Jr., CFP^®
August 1, 2005

Dwight writes, "In your model portfolio, you've suggested 20 percent in an index fund of real estate investment trusts (REITs). But in your 7/18/05 column (www.archierichards.com), you recommended buying stocks instead of real estate. Do you continue to favor REITs?"

That column, Dwight, suggested buying stocks instead of buying and flipping houses for investment purposes. Those who need a house to live in shouldn't hesitate to buy one, using a normal adjustable-rate mortgage.

No real estate bubble is forming. Real estate prices won't fall much, if at all. After adjusting for tear-downs and the building of 2nd homes, the new houses being built number about 1.2 million a year. This is 19 percent fewer than the number of new households formed each year.

REITs, however, seem overvalued. Their prices have risen so much that the income yields have declined significantly. Even if real estate prices stay the same for a while, the prices of REITs will probably go down.

Having recommended 20 percent in REITs in the past, should I now advise readers to place no money in REITs?

No. Cutting the diversification by 20 percent increases volatility and risk. Plus, my short-term predictions might be wrong.

I carry on this column on two tracks: First, I tell readers that on a consistent basis no one can predict the year-to-year changes of specific sectors or of the market as a whole. I therefore suggest purchasing all relevant investment sectors and rebalancing annually.

But on the second track, I occasionally make year-to-year predictions anyway.

Several years ago, when I first suggested an investment program, I intentionally omitted a key sector - commodities. I don't mean commodity futures, involving leverage and tremendous volatility. I do mean holding a wide range of commodities without leverage. Only one mutual fund did this - the Oppenheimer Real Asset Fund, a load fund.

I omitted this fund from my recommendations, because I was sure that government economic policies had improved so much that never again in our lifetimes would we experience the kind of inflation that prevailed in the 1970s, with commodity prices soaring. I believed this several years ago, and I believe it now.

What happened? Yikes, in the last two or three years, commodity prices soared! Most of them didn't go to their old 1980 highs, but they went up plenty. My readers would certainly have benefited from buying Oppenheimer's Real Asset Fund.

But it's too late to recommend this fund now. The disappearance of inflation is much too likely. I expect most commodity prices to head back down.

I continue on two tracks: Humbly, I recommend an investment program which assumes that no one can predict year-to-year trends. Haughtily, I occasionally make year-to-year predictions anyway.

What should you do about the REITs you may own? It depends, I suppose, on how much you trust my judgment. (If you don't trust it, you're probably not reading the darn column anyway.)

Other than vital annual rebalancing, you don't need to do anything. Over the last several years, rebalancing has caused the REIT sector of your portfolio to be reduced and other sectors that have performed less well to be increased.

You could cut your REIT holdings now from 20 percent of the portfolio to only 10 percent. But when would you return REITs to 20 percent, where it normally belongs?

No doubt I'll make that judgment in the future. But if you depend on me for this and I get hit by a truck and can't think straight, you might remain at the lesser percentages indefinitely. This would be a mistake. Over the long pull, 10 percent in REITs is too low. You'd be better off to have stayed at 20 percent all along.

It's okay with me if you pull back a little on REITs now. But it's a risk. In the long run, if you stick to my regular investment suggestions with rebalancing and disregard my year-to-year predictions, you'll come out just fine.