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I find it interesting that two of my favorite financial legends are on opposite sides of the diversification argument. What makes it harder is that I respect them both and I always find myself battling the question: too much or too little diversification?

Let's start with the pro-diversification argument. Sir John Templeton (knighted by Queen Elizabeth in 1987), deemed one of the greatest global stock pickers of the century (Money Magazine, Jan, 1999), was a die-hard value investor as he once said:

Search for bargains. You should try to buy that particular investment whose market price is lowest in relation to your estimate of its true value.

Sir John, who lived to be 95 years-old, seemed to be a product of the Grahamian-era where he continually taught that "wise investors must recognize that success is a process of continually seeking answers to new questions". Accordingly, Sir John was broadly recognized to be an extraordinary supporter of diversification as he often explained:

The only investors who shouldn't diversify are those who are right 100% of the time.

So how many stocks have you picked where you have been right 100% of the time? Be honest, every company has risk and that is why it's important to spread your risk to make certain that you can PROTECT YOUR NEST EGG AT ALL COSTS. As Sir John explained,

If you are diversified among different forms of wealth, nations, and industries, you'll be safe in the long run.

So now, let's turn the tables and talk about my other well-respected financial genius, Warren Buffett. He has been widely quoted as saying:

Diversification is protection against ignorance.

Wow Warren. That's a "smack-down" on diversification. Sir John's primary argument is that intelligent investors should focus on "all out" diversification; while the Oracle of Omaha claims that you are considered a moron if you over-diversify. Who's right?

I suppose that Buffett's argument rides on the notion that a concentrated and well-managed portfolio of a few larger bets is better than a less-focused portfolio of many smaller bets. As most know, Buffett has historically invested in fewer companies capitalized with more generous amounts of money. By investing in fewer companies, Buffett's approach has a more intense diversification strategy whereby he subscribes to the highly involved concept known as the "circle of competence". As Buffett explains:

You don't have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.

Now I'm confused. Buffett subscribes to having a few concentrated eggs in a smaller and more focused basket and Sir John subscribes to owning considerably more eggs in a larger basket. Both are great examples of success. What's the right answer?

How Much Real Estate Should I Own?

I started my career in real estate over two decades ago. I began investing in hard assets (not securities) in around 1990 and by 2002 I owned over 50 individual commercial real estate properties ranging from small duplexes to large shopping centers. The portfolio of assets was highly diversified and a majority of the income was derived from national retail tenants.

However, my net worth was 99% tied to one partnership. The income stream was diversified; however, the partnership was not. By 2004, my partnership was coming unglued and since fee owned assets aren't highly liquid I was unable to convert my ownership interest to liquid cash.

Finally in 2007, the big torpedo hit the ship when the financial tsunami, we now call the Great Recession, caused me to wipe out my retirement and by 2009 most of the fee-owned assets were under water. The debt market had dried up and some of the tenants were starting to bleed red ink. Some of the rent checks included Sam Goody's, Blockbuster Video, Goody's, Hollywood Video, Econo Lube n' Tune, AppleSouth, and Goodyear (NASDAQ:GT) - all of which had major financial problems - and most filed bankruptcy (except Goodyear Tire).

Now you can see why I believe in diversification. One partnership is like owning one REIT; however, the major difference is REIT shares are liquid. My lesson cost me over $10 million - whether it was on paper or in the bank - the end result was that I gambled on one partnership (company) and I lost.

So even Warren Buffett is a proponent of moderate diversification. His "crown jewel" holding company, Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) that invests in six baskets (categories) including: Insurance, Fuel/Power/Chemicals, Transport/Leasing, Manufacturing, Building/Construction, and Uniquely Positioned Brands. In addition, there are around 55 different eggs (companies) and although Buffett does not own over 100 companies his limited diversification strategy still provides an adequate "margin of safety" component. As Ben Graham, Buffett's mentor, wrote:

Diversification is one the cheapest forms of obtaining a margin of safety.

So should an investor own just one REIT with fewer revenue streams, like Berkshire Hathaway? Or, should an investor own multiple REITs, more like Sir John? To answer that, let's see what Realty Income (NYSE:O), one of the most diversified REITs in REIT-dom has to say. Remember, Realty Income has grown into a gorilla REIT and recently the company merged with ARCT making the combined REIT (Realty Income) the world's largest net-lease REIT and the 18th-largest publicly traded REIT. It's likely that Realty Income will soon be an S&P 500 company as the "monthly dividend company" has a current market capitalization of $7.74 billion.

Realty Income has set the bar for diversification and the company's "core of competence" has remained consistent going as far back as 1969 (when the company was founded). Even going back nineteen years (when the company went public on October 18, 1994), Realty Income's occupancy rate never dropped below 96%.

(click to enlarge)

Here's what the CEO (Tom Lewis) of "The Monthly Dividend Company" had to say about diversification (in a telephone interview last week):

We are huge proponents of diversification as it spreads risk, thus serving as potential protection against the adverse conditions and events that are a regular part of the economy. It is particularly important for income oriented investors to obtain their income from diversified sources.

Most of you know that I am a huge fan of the big "O" as the company's exceptional track record for paying out dividends is deeply rooted in the company's highly intelligent diversification fundamentals. Millions of investors have benefited from the rigorous application of Realty Income's diversification model - a testament that risk can be muted or smoothed out by an occasional outlier. As the "wizard of diversification" (and CEO of Realty Income), Tom Lewis explained (in a telephone interview last week):

In the case of Realty Income, the cash flow to pay monthly dividends is supported by the lease revenue from the 3,528 properties that we own, located in 49 states, leased to over 200 different companies in 49 different industries. Said another way, we own 3,528 eggs spread out over 49 different baskets that come from 202 different chickens on 49 separate farms.

Wow. That's one heck of a REIT model and clearly Realty Income has developed a hybrid investment strategy that has the depth of diversification that Sir John hypothesized (3,528 eggs) and the "core of competence" (49 farms) that Buffett relies upon. That power of extraordinarily successful diversification can be best illustrated with this chart below: 19 Years in a Row of Annual Dividend Increases

(click to enlarge)

How Many REITs Should I Own?

There is no question that Realty Income is one of the best examples of tenant-based diversification; however, does an investor need to own just one or two REITs, like Realty Income, or should he or she own 50 different REITs or more? There are plenty of options now as there are 131 U.S. equity REITs (with a market cap of around $541 billion) and 28 U.S. mortgage REITs (with a market cap of around $58 billion).

Combined the U.S. equity and mortgage industry has 159 REITs with a market cap of around $600 billion. So should I just spread the risk by allocating 10% to 25% of my net worth in equal buckets so that I have ownership in every single REIT? Or should I invest in a REIT mutual fund managed by professionals with a demonstrated track record for portfolio diversification and risk-adjusted stability? Or maybe there is a more passive option of owning high-quality managed index funds (ETFs)?

One Investment Advisor, Ascent Investment Advisors, believes that not all REITs are created equal, and the key to maximizing returns is by actively selecting stocks. As Andrew Duffy, senior portfolio manager of the James Alpha Global Real Estate Investment Fund (JAREX), explained in a recent Forbes interview:

ETFs typically own 100% of the constituents of a market index, i.e., "the good, the bad and the ugly." Conversely, mutual funds seek, through careful analysis and diligent research, to own only the good companies. Why would you want to own the bad and the ugly companies when you can invest via a mutual fund that seeks to own only the good ones?

This qualitative assertion is backed up by empirical evidence specific to global REITs: Over the past 10 years (2002 through 2011), the top-performing quartile of REITs each year outperformed the bottom-performing quartile by an average of 65%. The inescapable conclusion: not all REITs are created equal, and stock selection is key to maximizing returns on your portfolio.

As Amanda Black, CFA and Portfolio Manager at Ascent Investment Advisors explains (in a telephone interview):

Diversification is a risk management tool which embodies the maxim "don't put all of your eggs in one basket." It's widely held within the investment world that company-specific risk can be reduced by holding somewhere between 15 - 50 stocks. Industry-specific risk can be reduced by holding stocks from varying industries, country-specific risks can be reduced by holding stocks from varying countries and so on.

Mutual funds are attractive because investors are able to access real estate across the global landscape. Unlike the U.S., Europe and Asia Pacific market securities are trading below their net asset values (NAVs) on average, including many companies with high-quality assets and attractive growth prospects.

That broad real estate diversification strategy could become more important, should the impact of massive global stimulus and growth in emerging economies drive inflation higher. As Andy Duffy explained (in the recent Forbes interview):

When I first started investing in listed REITs over 20 years ago, there were only three countries on the map. Today, there are 25 countries around the world that have adopted the REIT (or REIT-like) structure as a tax-efficient way for small investors to achieve the many benefits of owning an indirect interest in high-quality, well-located and professionally-managed income-producing real estate. The industry has grown from a backwater with less than a dozen public companies, to a mainstream asset class with over 290 public companies with an aggregate market cap of over $800 billion.

So is there a premium to owning a larger REIT mutual fund, or even investing in REIT ETFs? In a recent Breakout interview, Vanguard Group founder and Wall Street icon John Bogle seems to make a strong case that statistics - the power of diverse mathematic investments - are sound. As he explained:

By absolute, mathematical definition, speculation is a loser's game and investment is a winner's game.

Bogle went on to say (and quoting his friend, Warren Buffett):

When the dumb money realizes how dumb it is and buys an index fund, it becomes smarter than the smartest money," and typically outperforms about three-quarters of the Street's brightest and highest paid stars.

Today there is an array of REIT products and each has its unique risk-adjusted diversification strategies. It seems that the more nimble investment strategies (like Buffett's) offer the best returns, while the more diverse options (like Sir John's) offers the highest "margin of safety" but with less reward. As Amanda Black, CFA, explains (by a telephone interview):

Diversification is good when it reduces risk without inhibiting returns. Diversification is bad when a portfolio becomes so diversified that mathematically it becomes difficult to outperform a benchmark or achieve a desired level of return.

Black goes on to explain:

The more money you have to invest obviously the bigger your average position size is going to be, particularly if you are trying to achieve an optimally concentrated portfolio. For really large portfolios this means many small cap stocks become un-investable. Essentially, your flexibility is reduced. The way a lot of manager's deal with this is by neglecting concentration - or said another way - over-diversifying.

As Black explains, the implications of over-diversification can mute performance and as Buffett said, "risk can greatly be reduced by concentrating on only a few holdings." Buffett's strategy of "cherry picking" the "best of the best" has been the mantra for his $400 billion dollar empire. As he explained:

Obviously, every investor will make mistakes. But by confining himself to a relatively few, easy-to-understand cases, a reasonably intelligent, informed and diligent person can judge investment risks with a useful degree of accuracy.

When You Boil It All Down

The primary question is, what type of investor are you? Do you prefer to be like Sir John and select securities more passively, or do you enjoy the more Buffett-like strategy of being "hands on"? Warren Buffett described the diversification conundrum as follows:

The strategy (of portfolio concentration) we've adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it rises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it.

I selected a random group of three REIT ETFs: Vanguard REIT Index (NYSEARCA:VNQ), SPDR Dow Jones (NYSEARCA:RWR), and iShares Cohen & Steers Realty Majors (NYSEARCA:ICF). All three ETFs own Simon Property Group (NYSE:SPG) and the $50.44 billion (market cap) mall REIT is also the largest holding of all three REIT funds. The average year-over-year total return for the group of ETFs is 16.62%.

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I also selected a random sample of global REIT mutual funds and the average year-over-year total return for the group is 29.34%.

Finally, I will conclude with my pitch: By filtering a diverse landscape of REITs, I recommend (and may soon own) a moderately diverse portfolio of REITs. With the use of my rigorous "margin of safety" application, interviews with management teams (and analysts), coupled with sound diversification, I intend to achieve the most favorable results (as you can see below). I am a few days away from launching my namesake Forbes newsletter, The Intelligent REIT Investor, and I will include two portfolios (each with between 15 to 25 REITs).

My portfolio below was designed for modest diversification (like Buffett) and I have over-weighted the REIT sectors with a highly defensive concentration of triple-net (and industrial) REITs. As most of you know, I am a bullish proponent of the stand-alone asset sector as I believe the sustainability fundamentals (i.e. contractually long-term leases) provide for an attractively well-balanced value proposition: stable dividends and moderate growth.

Six of the twelve REITs are categorized as triple-net landlords and the remaining six make up a diverse sector strategy of healthcare, retail, and self-storage. My aim was to anchor the dozen REITs with the consistent dividend fundamentals of the triple-net REITs and to balance the remaining REITs with attractive growth characteristics. As the chart below illustrates, my portfolio returned 37.51% (year-over-year) with an average dividend yield of 4.56%.

(click to enlarge)

In closing, investors should always diversify. Accordingly, your broad exposure to real estate should include minimizing tenant, property type, and geographic risk. To be properly diversified across geographic and property types, an intelligent investor should gain diversified exposure to commercial real estate mandated by the full spectrum of structured options. These options - customized, mutual funds, or ETFs - are becoming increasingly easy and that is also why it is essential that one should include diversification as part of your DNA.

(click to enlarge)

Diversification and buying with a "margin of safety" is a fundamental part of the "sleep well at night" formula. As Warren Buffett explains:

Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you'll find only a few companies that meet these standards - so when you see one that qualifies, you should buy a meaningful amount of stock. You must also resist the temptation to stray from your guidelines: If you aren't willing to own a stock for ten years, don't even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio's market value.

Ladies and Gentlemen: REITs should be a part of every investment portfolio. The value proposition is plain and simple: consistent income. By owning just one REIT (like Realty Income), a portfolio of REITs, a mutual fund, or an ETF, an investor is benefiting from the broad diversification fundamentals while, at the same time, building a durable dividend record rooted in stability and consistency. Whether you opt to invest like Sir John Templeton or Warren Buffett, the best advice on diversification can be explained by the legendary author and humorist, Mark Twain:

Put all your eggs in one basket and then watch that basket.

Rest assured, REITs should be a core basket (asset sector) and a primary ingredient for your SWAN (sleep well at night) strategy. Good luck and watch your basket grow.

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Source: SNL Financial

Special Thanks to Tom Lewis and Amanda Black who were both kind enough to provide me with quotes for this article.

Source: Can An Intelligent REIT Investor Over-Diversify?