Finance theory counsels that riskier asset classes carry greater volatility in their prices, a profile that necessarily spills over into returns as well. Stocks are more volatile than bonds, to cite the obvious example, and so the former tend to deliver higher returns compared with the latter over time. Unfortunately, finance theory doesn’t tell us what to do, if anything, when and if those relationships are thrown out of whack. That’s where common sense and the survival instinct fill in the gap.
Indeed, some of the volatility relationships these days may be deviating from terrain that some might recognize as typical. Nowhere does the atypical stand out more so than in the world of real estate investment trusts relative to the competing asset classes, as the following chart reveals.
In particular, the volatility for REITs leads the other major asset classes. (Volatility here is measured by the trailing 36-month standard deviation of monthly returns through March 2006.) Higher volatility implies higher risks. The question is whether REITs are deserving of their top-of-the-hill status as the most volatile asset class?
There are no absolutes for answering such matters, although one could make an argument that better candidates for the top volatility spot, using history as a guide, are commodities, emerging markets stocks and high-yield bonds. REITs, by contrast, are a fairly stable lot and not necessarily deserving of the current label. Some might even argue that REITs really aren’t a high-risk asset class at all. Perhaps, although you wouldn’t know it by look at REITs these days.
It’s worth considering that the driver of the relatively high volatility in REITs is related to the fact that the asset class has been in a bull market for some time. To be precise, you have to go back to 1999 to find calendar-year red ink for the Dow Jones Wilshire REIT Index. In every year since, REITs have taken wing. And so far this year, the party rolls on, with the index up by 10% in 2006 as of yesterday’s close.