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Do REITs (Real Estate Investment Trusts) Belong in Your Portfolio?

I recently received the following question from a reader:

“In all the books about index fund investing, the example portfolios generally look very similar to each other. But they differ on REITs. Some authors recommend a REIT index fund, while others do not. What are your thoughts: Do REITs belong in a portfolio?”

Background info: Real estate investment trusts (REITs) are companies that own real estate (or mortgages on real estate) for the purpose of generating income.

First, just to be clear, if you own an index fund that tracks a broad stock market index, REITs already are in your portfolio. So the real question is whether or not it makes sense to overweight REITs relative to other stocks by holding a specific REIT-only index fund.

Reasons to Own a REIT Fund

The primary reason that an investor might want to have a separate allocation to a REIT fund is that REITs have historically had a low correlation to the rest of the stock market. That is, they sometimes perform well when the rest of the market performs poorly (and vice versa). As such, including REITs in a portfolio often results in lower total portfolio volatility.

In his The Only Guide to Alternative Investments You’ll Ever Need, Larry Swedroe provides an excellent explanation as to why REITs tend to perform differently from the rest of the stock market:

“The long-term nature of many leases results in rents being more stable than corporate earnings. [And] since landlords are not generally trying to bring new technologies, new products, or new services to the market…REITs face fundamentally different business risks than do equities in general.”

And, conveniently, REITs bring this diversification benefit to the portfolio without sacrificing much in the way of expected returns. Because REITs are businesses (that is, because they entail risk), their long-term expected returns are closer to stock market returns than to (low-risk) bond returns.

Reasons Not to Own a REIT Fund

One disadvantage of REIT funds is that they often carry higher costs than other stock index funds. However, if you stick to the lowest-cost REIT funds, this difference is small enough that it shouldn’t be a major concern. For example, Vanguard’s REIT Index Fund has an expense ratio just 0.08% higher than that of Vanguard’s Total Stock Market Index Fund.

Another disadvantage of REITs is that they’re tax-inefficient (because they’re required to distribute 90% of their taxable income to shareholders each year). For most investors, this isn’t necessarily a problem–they can simply hold their REIT funds in tax-sheltered retirement accounts. But, if you’re in a situation where your tax-sheltered accounts are only a very small portion of your overall portfolio, REITs become somewhat less desirable.

Depending on who you ask, a third potential reason not to own a REIT fund is that doing so will overexpose you to the risks of one particular industry. Of course, others would argue that the fact that REITs carry different risks than other stocks (as explained above in the quote from Swedroe) is exactly why you would want to hold a specific REIT fund.

Lastly, every fund you add to your portfolio increases the complexity of managing it. For investors who place a particularly high value on simplicity, I’d argue that it’s better to forgo owning a REIT fund rather than a bond fund, a U.S. stock fund, or an international stock fund.

Teaching Kids About Investing: Giving Shares of Stock

Over Christmas, I got to thinking about one of the neatest gifts I ever got: When I was 8, my mom bought me a share of Proctor & Gamble stock. She explained that I now owned a piece of the company.

Of course, as an 8-year-old, I had never heard of Proctor & Gamble. So my mom took me around the house showing me all the products we regularly bought that were made by P&G: Tide laundry detergent, Charmin toilet paper, Bounty paper towels, etc.

Then, she took me along on the next grocery run and showed me the same thing. I was amazed. Not only did this company make a nearly-unending list of famous cleaning products, they made Pringles potato chips. Every kid in my class loved Pringles potato chips!

And now I owned a portion of this company. I thought that was very, very cool.

Focus on the Profits (not the Price)

Over the next few years, my mom made a point to maximize the educational potential of the gift.

My mom explained that, as a shareholder, I could choose between receiving money for my share of the business’s profits, or I could use that money to automatically buy more shares of the business–thereby allowing me to earn even more profits in the future. That sounded like a good plan to me!

She never even mentioned the market value of the stock. In fact, I didn’t realize until years later that the stock could be sold. The entire focus was on owning a company in order to receive a share of its profits. There was no mention whatsoever of the lottery of short-term stock price movements.

Every time there was a shareholder vote for new board members or important company policies, my mom explained everything to me so that I could choose what I thought would be best. (I distinctly remember voting against testing products on animals.)

My mom did everything she could to make the lesson as concrete as possible: When you buy a stock, you become a business owner, and you earn a share of the business’s profits for as long as the business is around. I was hooked. I wanted to know more, and I wanted to build my collection of businesses.

Why Not Give a Mutual Fund?

I’m as convinced as anyone regarding the benefits of index funds, but I’m of the opinion that a share of an individual stock (and a lot of time spent teaching) makes a superior educational gift for a young child. It’s far more concrete and, therefore, easier to understand and easier to get excited about.

Lessons such as diversification, minimizing costs, and so on can come later, after the child is interested in investing.

Retiring (at 65) Isn’t Supposed to Be Easy

One thing that keeps coming up in emails from readers of my new book is surprise at just how much money one should accumulate before retiring. “Is it even possible for people with normal jobs to save that much money?” has been a common question.

Yes, it’s certainly possible. But I never said it was supposed to be easy.

What Level of Saving Does it Take Per Year?

As a starting point for analysis, imagine that you’re planning on working from age 22 to 65. That means you have 43 years to save enough money to get you through (potentially) another 30. In other words, it’s possible that you’ll be spending down your nest egg for almost as many years as you spent building it up. If we assume that:

  • Your investment returns precisely match inflation,
  • Your income grows exactly in keeping with inflation,
  • The money you pay into Social Security ends up earning a rate of return exactly equal to inflation, and
  • Your lifestyle does not change (so your spending increases in keeping with inflation as well),

…then you would have to save 34.9% (30 ÷ 73, minus the 6.2% you pay into Social Security) of your income each year in order to retire as planned! Obviously, most people don’t save anywhere near that much.

Fortunately, your income is likely to grow faster than inflation over the course of your career. And your investments are likely to outpace inflation as well.

On the other hand, it’s likely that you won’t keep your inflation-adjusted spending flat from age 22 onward. Most people have kids and/or raise their standard of living over time. Also, many people don’t start investing by age 22.

So how much do you need to save each year? There are too many variables to give a rule of thumb that would work for everybody. For most people, it’s probably a good deal less than the 34.9% calculated above. But it’s also a good deal more than the 5-6% that the average person actually is saving each year.

Takeaway: If you want to retire at 65 (or earlier) with confidence that you’ll have the same standard of living throughout retirement that you had prior to retirement, you will have to make sacrifices that most people around you are not making. Your rate of saving has to be unusually high.

Why Retire at 65?

Lifespans get longer and longer, yet most investors are still planning on retirement at 65 or earlier. In other words:

  • We’re saving for longer retirements,
  • We aren’t dedicating many more years to accumulating savings than prior generations did,
  • We’re saving a smaller portion of our income per year than prior generations did, and
  • There’s no reason to think that our investments will earn higher returns than those earned by prior generations.

So it’s no surprise that (according to the Employee Benefit Research Institute) only 16% of workers are “very confident” that they’ll have enough money to live comfortably in retirement.

Thankfully, there’s no biological rule that says that humans must stop working at any particular age. And 65, 70, and 75-year-olds are (on average) in better shape physically and mentally than they’ve ever been.

To me, the obvious solution to both:

  • the societal problem of people not saving enough and
  • the problem faced by individual investors who feel they aren’t on track to retire at 65

…is to abandon the idea that retiring at 65 and traveling the world is something that most people can do.

Instead of asking, “When can I retire?” more investors should be questions along the lines of, “What do I want to be when I grow up? And how soon can I leave my current work to do that instead?”

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Can I Retire Cover

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  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
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2011 Tax Brackets and Standard Deduction Amounts

How Do Tax Brackets Work?

Just a brief reminder before we get to the tax bracket tables: Being in a given tax bracket does not mean that all of your income is taxed at that rate. Rather, only the portion of your income that is in that bracket is taxed at that rate.

For example, as you can see from the table below, a single taxpayer with taxable income of $8,501 would be in the 15% tax bracket. However, his first $8,500 of income would only be subject to a 10% income tax. It’s only the final dollar of income — the one dollar that’s in the 15% bracket — that would be taxed at 15%.

(See this article for a more thorough explanation.)

Single 2011 Tax Brackets

Taxable Income
Marginal Tax Rate:
$0-$8,500 10%
$8,500-$34,500 15%
$34,500-$83,600 25%
$83,600-$174,400 28%
$174,400-$379,150 33%
$379,150+ 35%

Married Filing Jointly 2011 Tax Brackets

Taxable Income
Marginal Tax Rate:
$0-$17,000 10%
$17,000-$69,000 15%
$69,000-$139,350 25%
$139,350-$212,300 28%
$212,300-$379,150 33%
$379,150+ 35%

Head of Household 2011 Tax Brackets

Taxable Income
Marginal Tax Rate:
$0-$12,150 10%
$12,150-$46,250 15%
$46,250-$119,400 25%
$119,400-$193,350 28%
$193,350-$379,150 33%
$379,150+ 35%

Married Filing Separately 2011 Tax Brackets

Taxable Income
Marginal Tax Rate:
$0-$8,500 10%
$8,500-$34,500 15%
$34,500-$69,675 25%
$69,675-$106,150 28%
$106,150-$189,575 33%
$189,575+ 35%

2011 Standard Deduction and Exemption Amounts

For 2011, the personal exemption amount will increase to $3,700 (from $3,650 in 2010).

The 2011 standard deduction will be:

  • $5,800 for unmarried taxpayers or married taxpayers filing separately,
  • $11,600 for married taxpayers filing jointly, and
  • $8,500 for taxpayers filing as head of household.

The additional standard deduction allowed for blind taxpayers and taxpayers age 65 or older at the end of the tax year will be $1,150 if married filing jointly and $1,450 if single.

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Topics Covered in the Book:
  • The difference between deductions and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
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Stock Market Mountain Charts

J.D. of Get Rich Slowly recently wrote an article about three personal finance posters that he likes. On the list was a chart typical of the kind that you’d see in a financial advisor’s office or a mutual fund’s sales literature. I’ve always called these “mountain charts” because they show a line of historical stock market returns that climbs upward like a mountain.

I have nothing against these charts themselves, but I think they’re often used to give an entirely-too-comforting view of investing in the stock market.

Visual Tricks

Mountain charts typically use a logarithmic scale, meaning that the y-axis shows exponential growth rather than arithmetic growth. So, for example, the tick marks along the y-axis might be at $10, $100, $1,000, and $10,000 rather than at $1,000, $2,000, $3,000, and $4,000.

One result of using this scale is that it makes bear markets look like no big deal. Click on the link above and look at 2008 in the poster. It’s just a tiny dip. Same goes for 2000-2002.

But for an investor who started investing in Vanguard’s Total Stock Market Index Fund 5 years before the market bottom in early 2009, this is the chart he’d be looking at if he signed into his account on 2/28/2009:

That’s not a tiny dip! For many investors, that kind of thing is terrifying. (Full disclosure: I’m inadvertently engaging in visual trickery of my own here. I don’t have control over the axes Morningstar uses for its graphs, so it’s important to note that the Y-axis doesn’t start at zero.)

Charts that give an overly-smooth appearance of market returns can trick investors into dismissing market volatility as no big deal. Result: They create portfolios with far more risk/volatility than they’re actually comfortable with, and they bail out when the market experiences its next decline.

Does History Repeat Itself?

In the long-run, stock market returns are driven by the output of a country’s economy. For the last 85 years or so — the period typically shown by stock market mountain charts — things have been (relatively) peachy for the United States.

But what would a similar chart look like for Germany? Or Brazil? Losing a world war or experiencing annual inflation in excess of 2,000% sends the value of stock investments rapidly toward zero. And those investments don’t necessarily come shooting back upward.

A chart showing U.S. stock market returns over the last 85 years is only valuable as a predictor of returns to the extent that the economies in which you’re invested experience economic growth similar to that of the U.S. economy over the last 85 years. That’s not exactly a sure thing.

How Long Is Your Investment Time Frame?

Finally, for most investors, what happens over an 8-decade time frame isn’t terribly relevant. For most investors, success is determined largely by the returns received during the period in which they have the largest amount of money in the market (i.e., the last decade or so of working years and the first decade or so of retirement).

Are Stocks a Bad Bet?

I believe wholeheartedly that a portfolio of index funds diversified across several countries is a good bet over a period of several decades. But there’s no guarantee that you’ll end up fabulously wealthy, standing atop a mountain of money. And whatever happens, it’s sure to be anything but a smooth journey.

Should I Diversify Among Brokerage Firms?

I recently received the following question from a reader:

Is it OK to keep all my investments with one company? Or should I diversify among brokerage firms?

The answer is that it depends on your situation.

Quick note: We’re not talking about diversifying your portfolio among different investments. (That one is a no-brainer: Yes, diversify.) We’re talking about whether or not it’s important to keep those investments at multiple brokerage firms.

Reasons to Use One Brokerage Firm

Really, the only reason not to diversify is to keep things simple. (Though that’s a darned good reason in my opinion.) By using only one brokerage firm, you have fewer accounts to check and less paperwork at tax time. In addition, having all your investments with one company makes it easier to:

  1. See your total asset allocation at any given time and
  2. Rebalance when necessary.

Reasons to Use Multiple Brokerage Firms

There are multiple reasons why it might be advantageous to use two (or more) brokerage firms, though it’s possible that none of them apply to you personally.

You’re Over the SIPC Coverage Limit
The Securities Investor Protection Corporation (SIPC) is somewhat analogous to the FDIC–but for brokerage firms. The SIPC steps in to make investors whole when they’ve lost money due to fraud or brokerage firm failure. They explain it this way:

SIPC does not bail out investors when the value of their stocks, bonds and other investments falls for any reason. Instead, SIPC replaces missing stocks and other securities where it is possible to do so. … SIPC helps individuals whose money, stocks and other securities are stolen by a broker or put at risk when a brokerage fails for other reasons.

SIPC coverage, however, is limited to $500,000 per customer. (And coverage of cash in brokerage accounts is limited to $250,000 per customer). If you’re over that limit, it’s probably not a bad idea to spread your investments out across a couple brokerage firms.

You Need Immediate Access to Your Investments
When a brokerage firm fails, it can take several months for the SIPC to replace investors’ lost securities. As a result, if you’re at the stage where you’re drawing money from your investments (and you don’t typically keep a great deal of cash available in checking/savings), it may make sense to use multiple brokerage firms.

You Like the Offerings of Multiple Brokerage Firms
Finally, there might be reasons other than risk-avoidance for you to use multiple brokerage firms. For example, it may make sense to have accounts at both Vanguard and Fidelity if you want commission-free access to Vanguard funds, but you also want to buy TIPS commission-free in your IRA. (Depending on the size of your account and whether or not you’re buying the TIPS at auction, Vanguard may charge a commission.)

I Don’t Diversify (Anymore)

Until a few months ago, I had IRAs at a couple different places. But when the rules changed on the 2% cashback Schwab credit card to allow the cashback bonus to be deposited anywhere, I moved everything over to Vanguard.

In other words, I don’t diversify across multiple brokerage firms. And that doesn’t worry me at all. But it may make sense for you to have accounts at multiple places.

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