The Smartest Dividend Stocks for Conservative Portfolios (and Why They Beat Bonds)

Building a diversified portfolio is crucial to your long-term investment success. While betting big on a few stocks might deliver outsize gains, that strategy can also backfire big time. An aggressive approach is not an investment strategy that someone nearing or in retirement, or who is naturally more risk-averse, can afford.

However, you also don't need to completely sacrifice returns to lower your portfolio's risk profile. One of the smartest ways to build a better diversified portfolio is to add some high-quality real estate investment trusts (REITs). These real estate companies provide steady income through regular dividends, making them similar to bonds, while also offering the potential for capital appreciation like stocks.

Here's a look at why REITs make smart investments and some ways to add them to a conservative portfolio.

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Weighing risks versus returns

Stocks offer investors the potential of earning high returns in exchange for taking on more risk. For example, over the past century, a portfolio of 100% stocks has delivered an average annual return of 10.5%, according to data from Vanguard. However, yearly returns have varied widely. While a portfolio of stocks produced a 54.2% gain in its best calendar year, it also delivered a 43.1% loss in its worst calendar year.

Adding bonds to a portfolio can help reduce the risk of a large decline. For example, the worst year delivered by a portfolio of 100% bonds was only a 13.1% loss. However, this bond portfolio would have only generated an average return of 5%. Given the lower returns of bonds, the more an investor increased their allocation to bonds, the lower their portfolio's overall return. For example, the classic 60/40 portfolio (60% stocks and 40% bonds) has delivered an 8.8% average return, with the worst calendar-year loss of 26.6%.

REITs provide investors with the best of both worlds, making them a smart complement to a diversified portfolio because they combine attractive income and growth potential, without increasing risk. Morningstar found that allocating at least 5% of your portfolio to REITs can yield higher returns with lower risk than a traditional 60/40 portfolio. Since tracking began in 1972, REITs have delivered an average annual total return of 12.6%, outperforming stocks during that period. While REIT returns have been lower in more recent years due to the impact of higher interest rates on real estate values, their 5.5% average annual total return over the past five years is still higher than the long-term return of bonds.

How to add REITs to your portfolio

Given the attractive long-term returns of REITs, adding a few of these dividend stocks to your portfolio makes sense. There are lots of ways to accomplish this goal.

You can build a portfolio of high-quality REITs. One top-notch REIT that epitomizes the sector's attractive investment qualities is Realty Income (NYSE: O). The company owns a diversified commercial real estate portfolio (retail, industrial, gaming, and other properties) across the U.S. and Europe net leased to many of the world's leading companies. Realty Income has consistently grown shareholder value. Since its public market listing in 1994, the landlord has failed to grow its adjusted funds from operations (FFO) per share in only one year (2009). Meanwhile, it has increased its dividend every single year (often multiple times), growing the payout by 4.2% annually. When adding its income stream (historical dividend yield of 6%) to its adjusted FFO growth rate (over 5% annual average), Realty Income has produced a positive operational return every single year (and an actual average annual total return of 13.5%). That combination of durability and steady growth has made Realty Income's stock 50% less volatile than the S&P 500. These features make Realty Income a great foundational REIT holding.

An alternative to owning individual REITs is to buy shares of a REIT ETF. For example, the Vanguard Real Estate ETF (NYSEMKT: VNQ) holds over 150 REITs, including Realty Income, providing investors with broad exposure to the entire REIT sector. The fund charges a low fee to passively invest in the space (0.13% ETF expense ratio) and currently has a dividend yield of over 3.5%. Since its inception in 2004, the fund has produced an average annual return of 7.5%, which is above the long-term return of bonds.

Smart additions to a conservative portfolio

REITs can deliver higher returns than bonds without increasing the portfolio's risk profile. Whether you build a REIT portfolio around a company like Realty Income or buy a REIT ETF such as the Vanguard Real Estate ETF, they make smart additions to a conservative portfolio.

Matt DiLallo has positions in Realty Income. The Motley Fool has positions in and recommends Realty Income and Vanguard Real Estate ETF. The Motley Fool has a disclosure policy.