I’ve read dozens of books about personal finance and investing. The basic principles of personal finance don’t change that much from person to person. Spend less than you earn. Use debt wisely. Save for retirement. Live a sustainable lifestyle. Of course, every finance writer will attempt to have a unique angle that’s fresh and easy to identify with…you don’t sell books by admitting that you’re saying the same thing that the last ten people said. If you read books about investing, though, I think you’ll find that the advice is very different. Large numbers of people actually disagree about investment – what it is, who should do it, how it should be done.
I can think of two very essential divides. One is between stock people and real estate people. Obviously, many people are both, but I’ve encountered many, many real estate people who are adamant that they’ll never invest in the stock market. Another is between people that see value in taking individual positions, and people who think that it’s a pointless errand, and keep their money invested in index funds. The index people would think it’s foolish to invest your money with a fund manager, because half of them won’t beat the market. And then there are, of course, also people who exclusively invest their money in fixed income investments. According to her wikipedia page, for instance, Suze Orman has almost all of her money invested in fixed income investments.
I’m going to focus on the divide between stocks and real estate. I’m going to ignore returns, although I would think that should be one of the primary considerations for investment. I don’t want to get bogged down with the historical returns, because I always hear such a wide range. For stocks, for example, the historical returns are often reported as being between 7-12% compounded annually. Some of the figures are including dividend reinvestment, while some aren’t. According to the chart 3/4 of the way down this page, since 1988 the S&P 500 has had a compounded annual growth rate of 8.8%. According to the Case-Shiller index, real estate has offered less than a 2% return historically. That number focuses exclusively on capital appreciation, of course, and ignores the fact that real estate can earn an income stream.
The real estate people all used to be fond of saying that real estate never goes down. For about a decade, they were right. Like any other market, though, real estate showed us that it wasn’t immune to the most basic tenet of economics, supply and demand. Warren Buffett talked about housing at the annual meeting. He said that at the height of the boom, builders were building about 2 million houses a year. Now they’re building about 500k per year (according to Buffett). Real estate people like real estate because you can touch it. You have more control over it. Having a rental property is like running your own small business.
Stock people will often site the headache that real estate often brings with it. Even if the returns are comparable, you’re spending your time and effort to earn those returns. Your time cost money. Liquidity is another big advantage stocks offer. The transaction costs are also much, much lower. You can sell $200k worth of stock for $5, or you can sell $200k worth of real estate and dole out nearly 10% of that to get the transaction to other people.
The biggest problem I see with real estate investment is its lack of diversity. Stocks aren’t just pieces of paper, they’re underlying ownership interests in businesses that make money. Lots of different kinds of businesses are available and it’s easy to diversify. Investing in real estate tends to be very localized. If you own a home, you’re already investing a large portion of your available wealth in a particular area. We just bought a piece of property in St. Louis, Missouri – and if something bad were to happen in St. Louis, that could lower the value of our investment tremendously. Just ask anyone that owns property in Detroit. Owning a diversified bundle of stocks gives you exposure to companies in different industries, and different places, that make their money in different ways. To me, that sounds safer.
I’ve also heard it said that investors should specialize in one thing that they know and that they’re good at. If real estate is what you know, they argue, that’s what you have the best chance of making money at. I think that argument makes some sense. It’s like Ricardo’s division of labor – you can’t become an expert at everything, so maybe you should just focus on something you know you can become good at.
At the same time, you don’t want to miss the opportunity to take advantage of an asset class that could boost your returns and help you meet your financial goals. Step outside your comfort zone a little bit. You should, at a minimum, understand what your retirement account is invested in. Have a plan. I think everyone should invest in what they know to an extent. At the same time, as long as you’re buying assets, you’re on the right track. I would advise against shunning an asset class altogether, especially one as broad and powerful as stocks. I saw a list of some things that millionaires had in common (on a blog – I don’t recall which one). One that jumped out at me was, millionaires believe that stocks are worth the risk. That makes sense to me. Happy investing. Thanks for reading.
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