“Stocks have generally returned ~7-9% a year compared to 2-4% for real estate over the past 60 years.” —The Financial Samurai
That, of course, is only one part of the story. Real estate is often seen as an “in between investment” whose returns fall between stocks and bonds in both volatility and return. But while I would be mistaken to not note that stocks have some advantages (such as liquidity), real estate is, in my humble opinion, a far better way to go if you want to be an active investor. If you want to be a passive investor, both stocks and real estate have their place. And for a retirement account or diversification purposes, I think owning some stocks and bonds is a perfectly good idea.
But for the active investor, real estate wins by a landslide. I’ve discussed many of the advantages of real estate before, but here I will focus on just one, the granddaddy of investment advantages: buying at a discount or “beating the market.”
That “Great” Stock Pick
The idea of “that killer stock pick” is so ingrained in our society that it has all but been parodied and meme-d to death. Seinfeld had a whole episode about it, and as usual, the plot highlights the randomness of it all. Jerry loses most of his money before the stock rebounds and the undeserving George wins a big payday.
Scott Trench illustrates that stock-picking is a fool’s errand by discussing how, generally speaking, when it comes to stocks, “The competition is out of your league.” Trench tells us about a friend of his who:
“…manages a pretty sizable fund at a well respected firm in New York City. He spends perhaps 80-100 hours per week studying his industry (technology stocks) and has done this for over a decade. He reads annual reports, market news, and press releases from his Bloomberg terminal, and studies investor decks the moment they become available.”
And because of this, he “…has beaten the market by about 1-2% per year.”
Are you really going to do any better?
In fact, if Scott’s friend has beaten the market, he would be an exceptional aberration. Here’s what Nobel Prize winner Daniel Kahneman had to say on the topic in Thinking, Fast and Slow:
“Some years ago I had an unusual opportunity to examine the illusion of financial skill up close. I had been invited to speak to a group of investment advisers in a firm that provided financial advice and other services to very wealthy clients. I asked for some data to prepare my presentation and was granted a small treasure: a spreadsheet summarizing the investment outcomes of some twenty-five anonymous wealth advisers, for each of eight consecutive years. Each adviser’s score for each year was… [the] main determinant of his end-year bonus. It was a simple matter to rank the advisers by their performance in each year and to determine whether there was persistent differences in skill among them and whether the same advisers consistently achieved better returns for their clients year after year.
“To answer the question, I computed correlation coefficients between the rankings in each pair of years: year 1 with year 2, year 1 with year 3, and so on up through year 7 with year 8. That yielded 28 correlation coefficients, one for each pair of years. I knew the theory and was prepared to find weak evidence of persistence of skill. Still, I was surprised to find that the average of the 28 correlations was .01. In other words, zero. The consistent correlations that would indicate differences in skill were not to be found. The results resembled what you would expect from a dice-rolling contest, not a game of skill” (Kahneman 215).
Yet humans, being what we are, always think we can beat the unbeatable. Nassim Nicholas Taleb, author of The Black Swan, refers to this as “the illusion of control” and says stock analysts, “have proved to be worse than nothing.”
Mutual Funds Versus Index Funds
Benjamin Graham—the father of value investing—would not have been surprised by these results. Graham notes that hedge funds are usually a worse investment than index funds (which just run on autopilot investing in a basket of stocks based on preset rules instead of being closely overseen by a manager) because of all the fees that come with hedge funds. In the updated version of his famous investing book The Intelligent Investor, the commentary notes the percentage of hedge funds that beat the Vanguard 500 Index Fund when fees are taken into account over different timespans. Here are the results:
- One Year: 48.9 percent
- Three Years: 59.5 percent
- Five Years: 51.4 percent
- Ten Years: 31.2 percent
- Fifteen Years: 28.1 percent
- Twenty Years: 14.9 percent
“Because of their fat costs and bad behavior, most funds fail to earn their keep. No wonder high returns are nearly as perishable as unrefrigerated fish. What’s more, as time passes, the drag of their excessive expenses leaves most funds farther and farther behind” (Graham 248).
Fees or no fees, you would expect the best hedge fund managers (who are paid millions and millions a year) to be able to consistently beat the market. You would expect wrong.
By the way, Benjamin Graham was Warren Buffet’s mentor. In 2008, Warren Buffet made a million dollar bet with the money management firm Protege Partners. Protege Partners could pick five “funds of funds” to go against Buffett. Buffett picked the Vanguard 500 Index Fund (which invests in the S&P 500). With only about a year to go in the 10-year bet, Buffett is crushing Protege Partners. After eight years, Buffett had a return of 65.67 percent. Protege Partners was wallowing at 21.87 percent (in large part due to their fees).
Buffett concluded that, “There’s been far, far, far more money made by people in Wall Street through salesmanship abilities than through investment abilities.”
This dynamic has lead some economists and financial analysts to develop what is called the Efficient Market Hypothesis, which states that it “is impossible to beat the market” because all the financial information is available and therefore the share prices will “always incorporate and reflect all information.” Thus, the share price is always right, more or less, and you can’t beat the market.
Related: 5 Ways Real Estate Wins Big Where Stocks Fall Short
There’s certainly some truth to this. There are so many analysts looking at these companies’ financials that nothing is going to go under the radar anymore. Much of it, though, I think is gobbledygook. During the tech bubble of the late ’90s, price-to-earnings ratios on some of the (often insane) companies that eventually went bust approached 100 (the average for the S&P 500 has been about 14). Does this represent an “efficient market”?
Instead, what I think the evidence points to is something closer to a simple inability to consistently predict the future with complicated things such as stocks. Regardless, the evidence is in, and it is overwhelming. If you can beat the stock market at all, it’s only by a tiny percentage. In other words, you are not going to be buying with any equity. You might as well give monkeys some darts and have them throw them at the stock pages in the newspaper.
On that subject, I should note that they effectively did this. “A March study by London’s Cass Business School found that among 10 million randomly created indexes, each with 1,000 U.S. stocks in equal weights (that is, monkey portfolios), nearly all of them beat a cap-weighted index from 1968 through 2011.”
And Real Estate?
The real estate market is much more local than the stock market. Every house, apartment, or office only has one buyer, whereas every stock is bought and sold by thousands. When an investor gets in touch with a motivated seller that owns a fixer they want nothing to do with, an opportunity to “beat the market” and buy with equity presents itself.
The mere fact the flippers exist and can continuously make money by buying low (then fixing up) and selling high proves the point. Have you ever even heard of someone “flipping a stock”? Perhaps arbitrage (usually done with currencies) would qualify, but that’s really a whole different matter.
Whether the stock market is efficient or just unknowable is somewhat immaterial. You can’t expect to consistently beat it. On the other hand, the real estate market is without question inefficient. Yes, this only applies to active investors, but it creates an enormous opportunity. And if you can gain enough equity to flip a house and make a profit, you can make enough to buy and hold and with equity right from the get-go.
Of all the advantages real estate offers, in my opinion, this is the biggest. Who cares if the annual return for real estate is less than stocks when you immediately start off with a 20 to 30 percent return? And, of course, you can compound that annual return by using leverage while insulating yourself from risk by buying with equity. This is the basis of the BRRRR strategy.
In summation, the key advantage of real estate is that, unlike stock investors, real estate investors can and do consistently beat the market.
What do you think? Does anything beat real estate for the active investor?
Weigh in below!