Many investors are more interested in avoiding losses than reaping gains. Dividends from REITs can help protect portfolios from downside risk.

Investors often overlook investment-grade, income-producing real estate, instead limiting portfolio allocations to stocks, bonds and cash. But a well-diversified portfolio that includes North American equity REITs can increase long-term, risk-adjusted returns - especially in periods of high market volatility or sharp downturns.

Markets crash more often and fall harder than traditional models of investment returns predict they will. The S&P 500, for example, has suffered monthly losses of about 16% or more on 10 separate occasions over the past 85 years. That's eight times more often than traditional portfolio models predict.

To look at how investors with low-to-moderate risk tolerance could build more resilient portfolios, the National Association of Real Estate Investment Trusts commissioned Morningstar to conduct a data analysis using the latest advances in portfolio optimization, assuming that investors are averse to the risk of large losses and want to protect their wealth.

The optimal loss aversion portfolio used in Morningstar's analysis is striking in its differences from a traditional mean-variance portfolio. For an investor with low risk tolerance, the loss aversion portfolio could produce long-term annual returns of 8.2% compared with 7.6% for the traditional portfolio, while an investor with moderate risk tolerance could expect long-term returns of 9.7% compared with 9.4% in the traditional portfolio.

The Morningstar analysis found that putting 14% to 20% of a global investment portfolio in publicly traded equity REITs could benefit investors. A key finding is the role of dividends from equity REITs in positioning portfolios to weather market storms. The stable dividends of REITs have provided investors with appreciably higher total long-term returns compared with other equities.

In fact, North American REITs outpaced large cap, small cap and international stocks, as well as U.S. bonds, over the period from late 1989 to the first quarter of 2011, with a compound average annual total return of 10.94%. The high dividend payout of REITs accounted for about 60% of total returns.

Michael R. Grupe, Ph.D., is executive vice president for research and investor outreach at the National Association of Real Estate Investment Trusts.