Reducing Risk in Tough Markets

REIT magazine: March/April 2016

Today’s stock market is like Tombstone, Arizona, in the late 19th century–even the most careful visitor can, with a single misstep, get whacked. A friend of mine took a 50 percent hit in staid oil/gas royalty trusts last year, and holders of supposedly safe pipeline master limited partnerships (MLPs) suffered almost as much.

During challenging times, investors think less about making money than protecting themselves from serious loss of capital. Because active trading rarely builds wealth, conservative investors seek to build long-term positions with little turnover in quality companies. But losses of 35 percent to 50 percent can rattle us all.

Some investors try to address this problem by using stop-loss orders; they will sell any equity position if it falls by a pre-determined percentage. I have used this strategy at times, both for my own account and for clients. But it must be used judiciously. (Although the exchanges stopped accepting formal stop-loss orders in February, investors can use “mental stops.”)

The biggest problem with stop-losses is that they will frequently cause the investor to sell out–and take a big loss–after the stock has already declined substantially. Perhaps the occasional disaster can be avoided, but at what cost? Few investors have the wisdom or courage to re-establish positions in these “losers.” So, unfortunately, they often sell low and buy high.

After much reflection over the years, I am convinced that a stop-loss strategy works best with stocks of companies whose earnings are volatile and less predictable. Every investment requires us to make assumptions and predictions about the future, but the likelihood–and magnitude–of error is much greater with these types of companies. As these stocks can decline by 50 percent or more, a stop-loss strategy at, say, 25 percent can be helpful. Examples include commodity-dependent companies, such as those in oil or iron ore, as well as technology and software companies that must continually develop the latest and greatest new products.

At the other end of the investment spectrum, most REIT stocks sit comfortably. Thanks to their predictable cash flows, we can have substantial confidence in future REIT earnings and values.

There are, of course, risks in REIT stocks, as in all equities. Where are property cap rates and values going? What about rising interest rates and bond yields? Will tenant demand wane, or will newly delivered product become excessive?

We investors certainly need to be cognizant of such risks, but unless any of them appear to be overwhelming, we would be wise to add to REIT positions at prices 25 percent lower rather than to sell them.

The lodging REITs, by their very nature, are higher on the risk spectrum. Hotel rooms cannot be leased, and lodging REITs have substantial operating leverage–operating expenses can’t be reduced quickly when revenues fade. Recessions can slash operating profits. So a stop-loss strategy may be useful when investing in these REITs.

REIT stocks can be volatile–often undeservedly so–over the short term. Yet, property values rarely are. If we are allowed to measure risk by the standard of a permanent loss of one’s investment capital, rather than volatility, I can think of no better way for long-term investors to reduce risk than to have a substantial allocation to REITs and to use stop-loss strategies for REIT shares very sparingly.

Ralph Block is the author of “Investing in REITs” and “The Essential REIT” blog. Views expressed are solely those of the author.

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