I’ve written a series of posts about 401k’s with the intention of encouraging each and every one of you to assess why you are choosing to ‘invest’ in your 401k over-and-above any other investment choice.
I received a comment from Timmers that I wanted to address here because he raises some interesting points … I will break up his comment into the relevant pieces:
As a person who invests in both 401k and Roth IRA as well as residential real estate …
Let’s stop it right there and understand that we are talking about three totally different things here:
1. 401k is not an ‘investment’ as I have previously defined it … it is a limited, tax-efficient savings strategy with benefits (e.g. employer match). Limited because the underlying investments are usually (not always) costly and relatively inefficient ‘products’ packaged for the employer by their 401k provider.
2. A ROTH IRA is not an ‘investment’ … it is a tax-advantaged vehicle in which it may be possible to make investments. Interestingly, you can usually use one to invest in a wide variety of means including: funds, stocks, real-estate.
3. Residential real-estate may be a good or bad investments, depending upon where, when and how you buy … coming off the top of the ‘bubble-and-bust cycle’, I doubt whether I need to explain this further, here. However, it is important to realize that residential real-estate is not the only form of real-estate investment available to you.
Anyhow, on with Timmers’ comment:
… I have to also add one other Major argument for real estate as a retirement strategy. That is, if investing right and long-term, real estate is much more of a sustainable investment. That is, if you have held it long enough to pay down the mortgage, you simply can live off of the rental income. After drawing out the rental income for one year—guess what? It hasn’t gone down in price but usually up—at least maintaining parity with inflation if not more (sometime much more if you invest right). AND…(the best yet)….you still have the same amount of money available to you as the year before plus a little more (if you haver raised the rent).
This is a masterful strategy of the Making Money 301 kind i.e. something that you want to consider when you have already made your pile of money and are considering (a) how to keep your principle (‘nest egg’) safe and (b) have a safe amount that you can withdraw to live off every year without worrying about inflation OR your money running out.
However, paying off the principle as a Making Money 201 strategy (i.e. building your ‘nest egg’) may not be wise as you then need to think about what you are going to do with the excess cash that the property is spinning off … you will need to invest elsewhere anyway.
That is, the simple difference between real-estate as a wealth-building activity and a wealth-sustaining activity is how much equity you allow yourself to have in each property that you own:
i) Wealth-building: more properties, with less equity in each.
ii) Wealth-preserving: fewer properties, with more equity in each.
Finally, Timmers switches back to 401k’s:
The problem with 401K investments is that unless you have enough to live off of the dividends (out of the question for the vast majority of people), you are drawing down your investment every year. It is not sustainable like real estate. Granted, you must maintain your residences, which is an ongoing cost, but a smart investor always plans for the major repairs/renovations and has money set aside for the smaller ones. To be honest, I am so tired of the constant 24/7 blather of the stock market investment complex that has its tentacles in every media outlet. They want to keep spinning a song that hasn’t produced for most mainstream investors the past ten years (but has for their jobs and income). I am grateful for AJC’s contrarian and no-nonsense approach to most of their blather.
To this, I can only say ‘thanks’ and add some recent comments from the Tycoon Report:
If this market were a horse, I think we would have shot it already to spare it further misery … we have to readjust our perspective of the US equity markets. This is not a buy and hold the S&P 500/DOW 30 market, and it probably won’t be so again until about 2015 – 2018. This is a sector driven market brought about by a slowdown in profit growth and driven by spiraling commodity costs. Index investors get crushed in markets such as these …
If you are a diversify-and-save-via-your-401k kind of ‘investor’, this Kind of makes you sick, doesn’t it?
Good Luck!
Great post AJC! More…please. 🙂
I don’t believe ANYONE’s predictions on when the market will be “good” again- there are just too many factors to really know. Say that they are right and the market is depressed for years. That is fine with me because a depressed market is the best times for building wealth! Do you remember Buffet’s quotes “be greedy when others are fearful and fearful when others are greedy” and “Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.”
>If you are a diversify-and-save-via-your-401k kind of ‘investor’, >this Kind of makes you sick, doesn’t it?
Not really… dollar cost averaging can still give returns in an overall flat market and honestly the more pessimistic people are the more I believe it’s the right time to be buying stocks. When the market does eventually recover I believe will be glad I did keep buying. Rebalancing will help protect those returns when I . Also a truly diversified portfolio doesn’t just rely on the DOW/SP500 so if small caps, foreign markets, bonds, or REITs do well my portfolio may still grow. The growth won’t be as good as if I had concentrated in the right asset class, but it’s a lot less risky because I won’t pick the wrong asset class to concentrate into! To use the horse analogy- some horse is going to win the race, so if I can get the right odds I can make money betting on all of them no matter who wins.
As for the 401K accounts- I agree that the fees are generally terrible and rob you of a lot of your returns. I would NEVER choose to open an account with such limited choices and high fees on my own. However, using a 401K account still makes sense for me because of the benefits. A match is an incredible thing, how else can you get an instant 50% guaranteed return?! The 401K isn’t a perfect investment vehicle, but it has enough benefits that it should have a place in most retirement plans.
-Rick Francis
I think you make a very important distinction between wealth building and wealth preserving in regard to real estate investing. I suppose I am currently at the wealth building stage and assume as I near retirement I will arrive at the wealth preserving stage. More then likely, however, I will continue to be aggressive with the equity in order to constantly leverage more properties and build more wealth.Thanks for your insightful analysis of my previous reply.
@ Guys, thanks!
@ Rick – Is it possible that the combination of (relatively) low returns and high(er) fees in your company’s 401k will pretty quicky eat up that one-off ‘free money’ 50% match? Check this post out:
http://7million7years.com/2008/05/23/will-you-ever-put-a-penny-in-your-401k-again/
Let me know what you think …
AJC,
I read the article and it was interesting- however I wonder if it is a really fair comparison. For the stock example assuming 8% annual for 30 year period is conservative estimate… Isn’t that the lowest return rate given the available historical data? I’m OK with that assumption as long as the real estate example is similarly conservative
I don’t know enough about real estate to know how the assumptions compare however…
A> How much work would it take to manage the property?
It seems like it would be a lot more work than rebalancing a few times a year.
B> Since the real estate case is a single property isn’t it much riskier? A flood or other natural disaster or difficulty getting renters could raise the costs estimates. If the cash flow was bad enough you could potentially lose the property. Shouldn’t the calculation put 6 months to 1 yr of mortgage payments in a CD as a buffer?
I didn’t see any mention of insurance or property tax premiums, is that assumed to be covered by rent? Didn’t it assume a mortgage rate of 5.25%? That seems too good of a rate to me… looking on bankrate.com a 30 year fixed rates is running 6.41%! Wouldn’t it would there be higher rate for a rental property?
If the comparisons are really equally conservative it demands some careful research on real estate.
-Rick Francis
@ Rick – The point of the post wasn’t to tell you to invest in RE instead of 401k, merely to challenge the ‘automatic millionaire’ assumptions out there today. I encourage you to run the numbers with whatever investments and rate/s of return that you like.
But, to answer your questions: I used 8% for stocks and 6% for RE because I consider these to be equally conservative; we are talking about 5 properties acquired over 30 years (anybody buying 5 could actually buy more under this model). I allowed 25% of rents (a useful Rule of Thumb) to allow for vacanices and holding costs for the RE and I used an 8% mortgage rate, not 5.25%.
AJC,
It does seem like a worthwhile alternative to research more- what about time commitment? What is a realistic estimate of hrs/year needed to manage a single rental proerty? Any suggestion on books that cover the basics well?
-Rick Francis
@ Rick – Good question/suggestion for a post … stand by. In the meantime, read anything by T John Reed (older) or Dave Lindahl (newer).
I like to use 6% – 10% for ROI on Real estate based on rental incomes, personally. 10% gives you a good margin for lack of occupancy, repairs, etc. Unfortunately these deals are very hard to find as prices are still too high generally. The bailout bill that just passed will only drag this on for more time. That said, I’m confident that there will be bargains in the next 3 years or so. Just keep an eye out and always look at the Price / Rent ratio of the property.
-Mike
There are several inherent problems with the save/invest/401K strategy. But, first one should start with facts. What is the average rate of return from folks invested in mutual funds? Not, what is theoretically possible, but what do folks actually get? The premiere data analysis is done by Dalbar, Inc. These studies are consistent with the other studies, including Vanguard’s internal studies. Then compare that with the rate of return for leveraged investment property.
Perhaps more importantly, is the fact that few people are able to save monthly for 35 years. Truth is life intervenes, like layoffs, sickness, extraordinary expenses, etc. that keep people from making inputs into their 401K/IRA for periods of time.
And finally, are taxes. Real estate ownership has inherent tax advantages all the way through the ownerhship cycle. 401K/IRA create tax problems for folks down stream when they least can afford it or have the ability to offset taxes.
Truth is, 401K/IRA save and invest strategies have failed for the last generation of folks and will fail for the next generation of folks.
Oh and one more comment. I love when people who haven’t accumulated wealth argue their strategies against folks who have!
@ Shaferfinancial – Thanks for the comments!
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