Broker Check

Investing in Real Estate vs. the Market (Part II)

| June 01, 2018

In Part I, we discussed the core benefits and drawbacks of investment real estate vs. the market. Hopefully, you were able to see that investing in real estate can prove quite fruitful if performed properly; the same can be said for investing in the stock market, which can provide many differing benefits apart from real estate. In this article, we will discuss the advantages and disadvantages of investing in the stock/bond markets. If you missed last month’s article where we discuss the advantages/disadvantages of investing in investment real estate, you can find it online on our website.

Investing in the Market – Advantages

As a financial advisor who manages many different clients’ accounts as well as my own investments, I have been through the trials and tribulations of the dot com bull market and the great recession. Traditionally, we as people seem to remember the market losses rather than the gains – an unfortunate aspect of human nature. However, as someone who has been able to achieve financial freedom while putting their children through college/grad school, I have seen the many benefits that the markets can offer. So let’s begin looking into those benefits.

The first primary advantage of the markets is the ease in which one can invest. You do not need to have a large capital outlay in order to invest; instead of tens or hundreds of thousands of dollars for an initial outlay in real estate, you can invest in the markets for virtually any amount of money. Thus, there are no significant barriers to entry, allowing people from all walks of life to gain access to the markets. The investment process is significantly easier as well. If you have gone through the process of buying real estate (especially since the great recession), you know all too well the mountain of paperwork and the hours sucked from your life from such process. Investment in the markets, on the other hand, is simple – a few clicks of the mouse (or a single meeting with us!) can get you invested.

The maintenance required by the investor is not nearly as cumbersome as investing in real estate. Whether you are simply investing with an advisor or indexing yourself, the time required to maintain your portfolio can be just a few hours a year if you so choose. This is not the case if you are a landlord – from collecting rents to maintenance to dealing with unruly tenants, you are going to be spending much more time each year dealing with the ins and outs of your investment (unless you hire a management company, which is significantly more expensive than what a financial advisor would charge on your portfolio).

A second advantage (somewhat linked to the first) is one of liquidity. Most market type investments have a three business day settlement, meaning the sale proceeds will be in your bank account three business days from the day of sale. I wish you good luck in doing the same with real estate, as it can sometimes take months for sales to occur (and many times, these sales can end up falling apart).

Another advantage of investing in the markets is the higher average return on investment. If we look at the 20 year annualized returns of different asset types, we can see just how well the stock market has performed:

First, it may make sense to explain what each of the asset types above are. The “S&P 500” represents the largest 500 US stocks by market capitalization (price times shares outstanding). “60/40” represents 60% invested in the S&P 500 and 40% in the Barclays US Aggregate Index (high quality US based fixed income). “40/60” represents 40% invested in the S&P 500 and 60% in the Barclays US Aggregate Index (high quality US based fixed income). “Bonds” represent the Barclays US Aggregate Index. “Gold” represents the dollar denominated price of gold. “EAFE” represents the MSCI EAFE, or the international stock index of the developed world. “Oil” represents the WTI, or the crude oil benchmark. “Inflation” is represented by the consumer price index, or the average rise in prices of various goods/services in the US.

Lastly, you can see “REITs” and “Homes,” which are representative of two real estate based asset types. “REITs” represent market cap weighted index of the universe of US based equity REITs. The REITs in this index represent real estate investment trusts, or diversified pools of commercial or residential real estate. This category shares many of the same characteristics of stock market investments – their prices are highly correlated to the overall stock market, they trade just like a stock, etc. The last category, “Homes,” represents the increase in median sales price of single family homes. This category represents the type of real estate investment that many people purchase when they invest in real estate, so this is a fair proxy to see how people have fared in real estate vs. the market.

As you can see, investment in any of the stock/bond market based investments (S&P 500, 60/40, 40/60, Bonds, EAFE) would have outperformed investment in single family homes. Many of these investments (S&P 500, 60/40, 40/60) either had returns that doubled the growth in single family home prices (or close to it). Of course, this chart does not take into consideration the use of leverage to increase return and also does not take into consideration the return component that rents may have (which would be partially offset by dividends/interest), but there are some truths to these numbers. Single family homes simply grow slower than the markets, and this is a very important advantage that one must consider when deciding where to allocate dollars.

Another very important aspect of investing in the markets is the ability to invest according to your risk tolerance. Are you a red 9 type of investor? You have the ability to invest up to 100% in stocks, and even within stocks you can shift to riskier types if you so choose (small cap/micro cap and (not something I would ever advise but…) penny stocks). Are you risk averse? You can invest in mostly fixed income or blue chip/staple/defensive stocks. Your ability to do the same with real estate is severely limited if investing in a single family home/condo.

Investing in the Market – Disadvantages

The characteristics of investing in the markets are not all gravy, however. First, if you are a DIYer and do not have any background in finance, deciding upon an allocation and picking ETFs/funds can be a daunting task. There is a wealth of information online, but determining whose advice you want to follow is an exercise in futility. For anyone who has tried to day trade themselves, they will know this all too well. On the flip side, seeing value in a specific home/condo in a specific neighborhood just seems easier (even if it is not!).

A second disadvantage is the lack of control you have in your investment. When you purchase a piece of real estate, you have the ability to add value to it by making improvements, staging the property prior to sale, etc. When you are buying a stock or mutual fund, you have next to no control in how the company performs against expectations or the forces that drive the overall market. Thus, you need to be at peace with this lack of control. If you put together this lack of control with the first disadvantage (a lack of technical knowledge), investing in the markets takes a leap of faith (and a good advisor).

We like to think that the liquidity of most market based investments is a positive, but if not utilized properly, it can be a huge thorn in investors’ side. Why? The DALBAR study can be indicative. This study released annually by a company called DALBAR tries to quantify the impact of investor behavior on real-life returns by comparing investors’ earnings to the average investment (using the S&P 500 as a proxy). Thus, it compares an individual who simply invested in the S&P 500 and STAYED the course over the last 30 years vs. the average stock investor’s hypothetical return over that same time frame.[1] The results found that while the S&P 500 earned 11.1% annually, the average investor earned 3.7%. That means stock-fund investors underperformed the market by approximately 7.4 percentage points annually for three decades.

What was the reason for this difference? The study cited that the largest reason is poor investor behavior, as investors chase returns—jumping aboard after a streak of hot performance and diving over the gunwales after it goes bad. When the market is up, clients forget the pain of past plunges, such as the financial meltdown of 2008, and feel they can accept more risk. This is naturally the worst possible time to jump into the market – stocks at this point may be overvalued, and a reversion to the mean is not too far off. Investors, however, have a strong loss aversion (as I mentioned earlier), and are not always cognizant of the idea that investing carries financial risk. When there is a market correction, suddenly, the market has become the Titanic and clients want to run for the lifeboats of cash; I have seen this very situation happen several times during the most recent downturn. Thus, the ability for the common investor to get in and out of the market can be a huge negative if used improperly.

These are just a few of the main advantages/disadvantages, and taken in conjunction with last month’s article, you can see there are benefits and drawbacks of both types of assets. In a perfect world with enough capital, you may want to consider both. But if you have limited assets to invest, you should carefully weigh each type and decide which best fits your financial goals. Of course, we are here to help – so if you have any questions, please feel free to reach out to us!

[1] Average investor returns are measured as mutual fund sales, redemptions and exchanges each month to reflect investor behavior in the aggregate, as if the sum total of all inflows, outflows and exchanges were made by a single investor. That hypothetical investor's return is regarded as the average return for purposes of this study.

Karen DeRose and Anthony DeRose are registered representatives of Lincoln Financial Advisors.

Securities and advisory services offered through Lincoln Financial Advisors Corp., a broker/dealer (Member SIPC) and registered investment advisor. Insurance offered through Lincoln affiliates and other fine companies. DeRose Financial Planning Group is not an affiliate of Lincoln Financial Advisors.

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