You can find this post in this weeks Carnival of Personal Finance ….
As I mentioned yesterday, I drafted yesterday’s and today’s series of two posts before the latest round of stock market crashes … it seems that with all the money LEAVING the market at exactly the wrong time – i.e. the market bottom (or, close to!) – everybody is suddenly ‘anti-stocks’ … of course, as soon as we get towards the top of the next bull market all the pro stock / anti-real-estate people will come out of the woodwork again … and, the cycle repeats 😉
There is a great argument for investing in stocks and businesses: Warren Buffett has done it successfully for 40+ years turning himself into either the #1, #2, or #3 richest man in the world (depending upon what’s happening with Bill Gates and Carlos Slim on any given day).
Warren has shepherded his company, Berkshire Hathaway to compounded returns averaging 21% for the past 20+ years doing the one thing that us ‘mere mortals’ have difficulty doing: picking ONE horse and riding it all the way home.
What we seem to prefer to do is invest in Mutual Funds, the stock market equivalent to following all the advice of a ‘top tipster’ in the Saturday Racing Guide for either the horses or the dogs (how many of these newspaper ‘tipsters’ are rich, anyway? If not, how good are their tips, really?) …
… or, we plonk our money into Index Funds, which is the stock market equivalent to betting on every horse in the damn race!
By betting on every horse or – in this case – stock, we are aiming exactly for the average result … for the time frame that we manage to stick it out.
But, wouldn’t we get better results if we simply bought all the stocks in the Index Fund that are above average and ignored all the others? 😉
Simple and powerful strategy, no?
No!
We know that the logic is there: by simply NOT buying the dogs, and concentrating on the (even slight) favorites, we push the odds markedly in our favor.
But, when it comes to stocks – or horses and dogs for that matter – the form guide, tips, and other sources of ‘best buy’ information have proven to be highly unreliable.
The past is simply NO guide to the future, so we are left with either relying on others to pick some winners for us (they will lose us money, relatively speaking, because of the fees they charge, but at least we’ll feel good about having an ‘expert’ doing our guessing for us) or ‘playing the whole card’ i.e. buying the Index Funds …
… the net result is that we tend towards the average (returns) or worse … never better.
So, quite rightly, we talk about the stock market in terms of aiming towards (but, never quite getting there) long-term average returns.
Yet, the total opposite applies to real-estate:
The pro-stock / anti-real-estate movement [AJC: I am neither; I am simply pro-profit 😉 ] points to the average return from real-estate and compares it to the average return from stocks and says “aha … stocks are better!”
Putting aside the leverage, tax, income and other benefits of real-estate, the problem is that nobody buys the whole card when it comes to real-estate …
… there is no Index Fund for real-estate!
[AJC: well, there might be an artificial ‘index tracking’ ETF that does this … but do you know ANYBODY who’s ever bought it? 🙂 ]
You either buy a Mutual Fund (technically, called a REIT) that buys a selection of real-estate for you, based upon what some inside ‘expert’ predicts will do well (after fees, fees, fees) …
… or, you buy one or more properties yourself.
You see, unlike stocks, you NEVER buy the market, so comparing average returns is just plain dumb.
There is also one other key difference:
You DO know how to pick real-estate … you have at least some experience: you bought your own house, didn’t you?
You chose a ‘nice area’, close to schools, transport, in a nice neighborhood, didn’t you? And, if you still live with Mommy and Daddy, well, they bought a nice house, etc., etc. … right?
Gotcha!
Right there, you bought in the top half of the market in terms of growth … you just beat the (real-estate) market average!
When it comes to stocks, not one of us is Warren Buffett, so we ‘gamble’ on the performance of some market index that we don’t really understand …
… but, when it comes to real-estate, we are all like Warren Buffett – we all have the capability to pick the horse … oops, house … that will perform better than average.
And, even if we only get ‘the average’ return on our real-estate investment … we are going to do two things that we are never going to do with stocks:
1. We are going to leverage our investment – we will almost always take a mortgage on real-estate, but we will hardly ever borrow to buy an Index Fund
2. We are going to invest for the long-term – we will most likely stay in the real-estate investment for at least 7+ years, but we will most likely try and time the market (i.e. get scared and sell at the first sniff of a ‘down market’) if we buy stocks or Mutual Funds, thus absolutely killing our potential returns.
Still don’t believe me?
Then why is that conservative old banker prepared to back your real-estate acquisition with a couple of hundred grand?!
[AJC: at least until a couple of months ago … and, again in a couple of months time]
See if he’ll do the same when you want to go and visit your bookie … or stock broker 🙂
Bad analogy.
Warren Buffet doesn’t “pick” a horse. He breeds it, trains it, feeds it, trains it some more, and picks out its staff.
Warren Buffet does not just buy stock; he in involved in the underlying companies. To suggest he is gambling on someone else’s project is just wrong.
Great points all around Adrian and good analogies!
@ Dog & Scott – Good analogy? Bad analogy? Guess I’m having a bet each way 😛
It is a misnomer to say that Warren Buffet only invested in “One Horse” if you look at Berkshire Hathaway it only serves as a holding coming for all of Warrens many other holdings like Coke, BNI, WF ect. In fact Berkshire doesn’t even operate in any of the same capacities as when he bought it.
coming = company
@ Drew – BRK is the jockey, their investments are the horses. And, you are right of course, they bet on a number of horses, but in a HUGE field.
BTW: Warren is on record (and he repeated this at the AGM that I attended this year) as saying that he WOULD invest up to 60% or more of his capital in just one investment (a.k.a. back just one horse) …. Charlie Munger said he would even go as high as 80%. He said that his problem is that his investment capital is too large: no one horse is suitable right now.
Once again, good analogy. One of the key points to this post was concerning real-estate and how a person is following more of a Warren-esqe style of investing when they purchase real-estate as an investment property instead of plunking down that 20% down payment money on REIT’s, ie; scout out the location, check out the school systems, the crime rates, etc, etc.. then they buy and HOLD for the long term.
Also ask yourself this simple question, Did Warren Buffet start out with BILLIONS of dollars to be “involved in the underlying company”? No, he started out like the rest of us and built up a few “million” doing ground work, studying individual companies and investing what he had available in them, before he could get too “involved” with any major underlying companies and begin purchasing majority shares of the whole.
Go to Coca Cola with even a few tens of millions and try get involved with the company other than simply buying shares in their stock and the corporate leaders will probably look at you like your standing on the street corner with a coffee can full of change…
@ Scott – Good pickup on the point about RE … the critical point is that we should invest in either/or stocks and RE, but in the same way (pick just one or a few) if we are serious about our financial future.
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I have to agree that Warren Buffet is NOT passive after he invests in a company. Using a housing analogy he buys fixer-uppers and has his own team of talented contractors that fix things up. That fixing up adds value, I wonder if there is any way to quantify how much of his returns have been from picking the right company vs. making the company function?
REIT index funds do exist- VNQ is an example here is the description: The fund normally invests approximately 98% of assets in stocks issued by equity real estate investment trusts (REITs) in an attempt to track the investment performance of the Morgan Stanley Capital International (MSCI) US REIT Index.
I’m not sure that the skills picking a good house to live in really translate to picking good investment home. Why is a nice house in a good neighborhood necessarily a good investment? I’m sure a lot of nice homes in good neighborhoods are upside-down right now because they were bought at too high of a price! I would look for a house that woulb be easy to rent – growing area and rental market not saturated. Ideally the neighborhood is nice enough to feel safe but that might improve in some ways between when I buy and sell. Finally, I would want it to be selling at a price that would make renting immediately cash flow positive.
-Rick Francis
@ Rick – I think almost 100% of his returns have come from selection; I do not believe that WB is a ‘fixer-upper’ at all. Rather he is a ‘vulture’: buying undervalued assets then making better use of their cashflow (by making even more acquisitions rather than issuing dividends) than their previous owners. Simple 🙂
BTW: a Fund-of-REITs is still tracking a relatively small, unbalanced subset of what constitutes the US property market … by contrast, you can easily buy an Index fund that tracks a representative portion of the US largest businesses.
As an aside, most of the large real-estate is owned by those large US – and, overseas – corporations, rather than REITS.