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I wrote a series of posts about a hypothetical ‘battle’ between the Mighty 401k and Humble Real-Estate. For those with a sharp eye, I posed the original post as a question, not a recommendation.
However, it is my contention that, for many people, the 401k will lose when compared to many other forms of active investment – including, but not just real-estate!
For those of you who read this highly contentious post – and, the follow-up posts (which you can find by following the ‘track-back’ links listed at the bottom of the original post) – you will, hopefully, realize by now that my point was simply this:
Don’t blindly follow the pack by simply plonking your money into your 401k to get the ‘free money’ employer match and tax-benefits!
Do your homework first … there may be better investment options out there, for you.
The example that I used was comparing the 401k to investing in 4 or 5 single-family homes as rentals; Pinyo said that he ran the numbers and the 401k ‘won’ (but, he didn’t provide any further details) and Jeff says that he ran the numbers are found it to be a close call – you always know that you’re in trouble when somebody begins with “I appreciate your attempt …” 😉
Anyhow, here’s Jeff’s comments:
I appreciate your attempt at explaining why Real Estate investing should at least be considered over equity investing in an employer-matched 401K. I ran the numbers using your assumptions (adding in tax consequences–property and income–and cost of property insurance) and, although the annualized return was much closer, your Real Estate investing scenerios came out slightly ahead. I expected this result as investment property investing usually carries increased risk (and hand holding) and thus should provide increased reward.
In going through the process of comparing investment options, I was suprised by a few things. 1) the Real Estate investment option, according to your scernio, suffered from 8-15 years of undiscussed or accounted for negative cash flows after costs, such as property tax, insurance, mortgage payments, and your 25% unrealized income either due to maintenance or unoccupancy, and 2), more importantly, the overall outcome (equity v. real estate) varied drastically based on 2 assumptions: estimated appreciation of real estate over 30 years and estimated return in the equities market over 30 years. Even a 1% point swing in either of these assumptions made a huge difference in projected outcome, i.e., which investment option was better.
I looked through your blog (not exhaustively) for a post discussing your reasoning behind these 2 estimates, but failed to find one. Since it seems that the accuracy of these estimates (best and worst cases scenerios over 30 years) is essential in determining if either investment option has a clear advantage, I was hoping you could either point me to a post of yours discussing them, or let me know of any books, articles, etc, that led you to your estimates.
As I said to Jeff, the mere fact that it is at least a close call means that it is no longer sensible to just automatically plonk your money into a 401k just to get the employer match.
Surely, your goal isn’t to gain ‘free money’ and/or tax benefits …
… it’s to end up with a sh*tload of money, right?!
You can only do that if you investigate all the options available to you. By that, I mean all the options that interest you!
For me, that’s stocks (but not mutual funds); real-estate (but not single-family homes); gold/silver (but not other commodities); etc.
For most people, it will simply mean putting up the 401k scenario against one or two other choices, just as I did in the original post with real-estate.
With all the online calculators available out there, it’s not hard to do a rough analysis, using the 401k option – with numbers that make sense to you – as your baseline.
If, as Jeff found, it turns out to be a close call, then stick with the 401k … it’s simple and at least gives the appearance of being low-risk.
For me, though, if it’s a close call I usually choose the most ‘active’ form of investment as I know that I haven’t factored in all the upside potential.
But, to answer Jeff’s questions; it all boils down to your estimates – or at least appears to:
Now, while I used 8% as the return from the 401k to allow for the very-slight-risk (even over 30 years) that you will pick the worst market time to start investing, you will find that the typical index fund will return upwards of 11% over 30 years minus costs (index fund costs; sales commissions; employer admin; etc; etc.).
This all depends upon your 401k and the options that your employer allows – a reasonable rule-of-thumb is to allow 1.5% for costs. So you could rerun the numbers at 9.5% returns.
Now, what company match will you assume? I allowed 100%.
However, will your employer give you 100% match now and for the next 30 years (since, you’ll likely change jobs 4 times in 30 years)? Think very carefully before answering this question!
You will also find that your contributions are maxed to $15k or so a year, which kind of makes this analysis moot, because any serious investor will be wandering what to do with the rest of the money that they want to invest.
On the real-estate side, according to Todd Ballenger author of the new book Borrow Smart, Retire Rich “since 1945, the median house price in the United States has risen by an average of 6.23% per year”. Others will quote studies saying that single family homes only keep pace with inflation (currently 4% – 5%).
So, I selected 6%, which I feel is a little low, and allowed 5.25% for a fixed mortgage (which, now, is also a little low), and 5% rental return (which will start to become a little low again), and 25% of all other costs (incl. insurance, property taxes, R&M, etc.) which could be high or low.
Again, run the numbers and if it’s a close call, don’t bother with the investment option.; stick with the set-it-an-forget-it 401k.
But, let me pose a small question: does investing either way do it for you?
Does it make your Number?
If either way does (and, in the time frame that you want to get there), don’t sweat it … again, go for the 401k and relax.
Life wasn’t meant to be that difficult 🙂
But, if it does not ‘do it for you’, hang tight, I have more for you soon …