Prior to learning about real estate investing, I thought that the best way to satisfy my need to take control of my finances was through investing in stocks. Specifically, I thought that I could improve my finances by researching and analyzing individual companies and placing careful bets on select stocks, with the expectation of beating the market.
In this article, I want to explain how foolish stock picking is, especially for a young person worth less than $1 million. I want to describe how incredibly outmatched young investors like me are in successfully picking stocks, and how even an investing prodigy like Warren Buffet would be wasting his time picking stocks at a low level of net worth.
Instead, ambitious investors worth less than $1 million should focus on actively managed assets like real estate or small businesses, while less ambitious investors should simply put their money into passively managed index funds.
There is just no point in expending energy researching individual stocks for 99% of the population.
Below, I’ll illustrate two reasons why stock picking makes no sense and follow with an explanation as to how a similar effort directed at real estate CAN generate outsized returns for the beginning investor.
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Two Reasons Why Stock Picking is Ridiculous
Reason #1: The Competition is Out of Your League
Let me tell you about a friend of mine who invests in the stock market. We’ll call him Matt.
Matt 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.
He also attends annual shareholder meetings, networks directly with executive officers at the Fortune 500 companies that he invests in, and meets with other large stakeholders from all over the country. Matt is one of the most well-informed people in his entire industry and is therefore in perhaps the best position imaginable to predict the future success or failure of these companies.
After hundreds or thousands of hours of careful research and methodical number crunching, Matt leverages his research and his decade of experience to purchase tens of millions or hundreds of millions of dollars of equity in the companies he selects.
Matt’s target is to be correct just 60% of the time. If he hits that target, his fund will make hundreds of millions of dollars, and he’ll take home a fat bonus. He’s well incentivized to squeeze every additional basis point in return he can each year for his investors.
Matt is every bit as smart as you, and as an alumnus of an elite business school, he is better educated than you. He’s willing to work hundreds of hours per week and to do everything in his power to get access to critical information as soon as it becomes available. He studies the market all day long and goes home to dream about it at night. He is training young analysts (also smarter, better educated, and working longer hours than you) in his approach to perform ever more thorough due diligence. Because of his training, expertise, resources and results, thousands of wealthy investors give Matt hundreds of millions of dollars to invest for them via his fund.
Matt’s fund has well over $500 million in assets under management. He buys and sells enough shares of multi-billion dollar companies that he can single-handedly change their market price with individual transactions.
Because of his efforts, resources, training and expertise, Matt has beaten the market by about 1-2% per year throughout his history as an analyst. He charges high fees for this extraordinary performance, and his happy investors end up slightly better off than if they had invested in a passive fund investing in technology stocks. They are very lucky to invest with Matt because 85% of his competitors failed to beat their benchmark last year, after fees.
You will have to get up pretty early in the morning to match the performance of Matt’s fund with your own stock picking. Best of luck to you.
Reason #2: The Alpha is NOT Worth it!
Ok, you don’t believe me. Maybe you think Matt (who closely resembles one of my relatives) doesn’t exist. He’s a fairytale I invented to scare you. Even if he does exist, you can beat him. He’s TOO informed, TOO smart, TOO big. You’re better than him. You get what the small players are doing; you see the stuff the Wall Street guys can’t, or won’t. You are a prodigy.
I get it. I was the same way. I thought I could beat the pros, too. I thought I was the next Warren Buffet, only better!
I respect your ambition and confidence. But you’re just as ridiculous as I was. That’s because, like me, you aren’t mega-rich. Even if you are a stock picking prodigy — the greatest of all time — it is only worthwhile to devote a serious effort towards beating the market if you have well over $1 million to invest.
Ninety-nine percent of us don’t have a meaningful amount of capital to invest. Without a meaningful amount of capital, chasing above-market returns, especially those in the stock market, is a total waste of time.
Here’s a reality taken from my personal life:
I decided to try my hand at stock picking early last year when I had saved a nifty $5,000. I spent hours reading the annual reports of so-called “micro-caps” (companies with less than $100 million in market value). I read annual reports, got in touch with key executives, called up stores that sold or used their products, and performed all other types of crazy due diligence.
And guess what? In 2014, a year when the S&P shot up 11.4%, I managed to lose money. There are three possibilities as to why I lost: I’m either really unlucky, really dumb, or stock-picking is just really, really hard. It’s probably all three.
Let’s suppose that things had gone differently. Let’s suppose that I was a stock picking prodigy like Matt or Warren Buffet. Let’s suppose that instead of losing money, I earned a 25% return on my $5,000 investment and brought home a cool $1,250 in 2014. Let’s also suppose that I was able to beat full-time investors like Matt, Warren Buffet, and the rest of the market on just 10 hours of research per week in my spare time.
I might feel like a badass for getting that 25% return, but the reality is very far from badass. In this scenario, I would have beaten the market’s return of 11.4% by 13.6%. That additional 13.6% return (which, again, was a truly extraordinary achievement) is what investors like to call alpha. On a $5,000 investment, my alpha of 13.6% equates to $680.
Over 500 hours (50 weeks at 10 hours per week in my scenario) of research went into that alpha last year. That’s roughly $1.36 per hour.
I’d have been much better off working a minimum wage job, building a passive asset, or focusing on saving more money. Picking stocks was an utter waste of time from a profitability standpoint. I got hosed! Even if I’d done the same with $50,000 to invest, my returns in this scenario equate to just $13.60 per hour!
And let’s not forget: Realistically, even great investors only dare to hope for 1-2% above market returns over the long run.
Stock picking, even for a prodigy, is just a complete waste of energy for anyone with low net worth. Chasing alpha in the stock market only makes sense if you have millions, or better yet, hundreds of millions of dollars to invest.
But even with hundreds of millions, you still have to face off with Matt.
So What Should You Do With Your Money?
If you aren’t interested in working on your investments, then go with a passively managed index fund. It’s the simplest and probably the most powerful truly passive investment you can make over the long term.
If you are interested in being an active investor and want to make the most of your money, then real estate is probably one of the better ways to go.
Here are some of the reasons why I invest in real estate instead of stocks at a low level of net worth:
Reason #1: The Competition is Less Fierce
Remember Matt? Matt’s in New York. Matt’s also got $500 million to invest. He could probably beat me here in my local Denver market if he wanted to, but investing his $500 million fund $250,000 at a time in small Denver multifamily residences is not a good use of his time. Matt doesn’t have time for small fish like that. He also can’t be bothered to learn about the new parks being built near my neighborhood, the light rail that will have a stop 5 blocks away, or the vacant lot that’s going to be built up next year. Those things give me an upper hand against the big money like him.
The investors I compete with are all smart, educated, and intelligent folks. But they’re also friendly faces, people I’ve met through BP and local networking events. They don’t have hundreds of millions to invest, and even in the hot Denver market, there is opportunity to go around. It’s no picnic investing in real estate, but at least there aren’t many Matts around.
Reason #2: Unlike Stocks, Added Work Equals Added Returns
In the stock market, more research does not correlate with higher returns. As often as not, the investor who does his homework loses just as much money as the fool that throws his money at companies blindly.
In real estate or business, taking on the work yourself can and does result in increased returns.
When I bought my duplex, I spent weeks making the place look pretty with new cabinets, appliances, paint, plumbing, and drywall repair. Just this past weekend, I spent my Sunday putting up new shutters, planting bushes, reseeding the lawn, and cutting out overgrown branches. These projects cost me time and money for materials. But I saved thousands of dollars by doing this work myself instead of hiring a contractor. For someone with a low net worth (like me), these savings are HUGE as a percentage of my overall wealth. A far greater per hour return than I could get researching stocks.
You can argue that my time might be better spent hiring and managing others to do work on my property for me, and you might be right. Handyman work may or may not be the highest use of my time. That said, I firmly believe that given the option of picking stocks and working on my property, working on my property produces a higher total return for me every single time.
Reason #3: Leverage
While it is possible to use leverage as a stock investor, it’s very difficult to do so consistently over the long term. That’s because stocks are so volatile. Banks don’t want to give you their money to play with for the next 30 years when there is a very good chance that the market will correct enough for your equity position to fall to zero at some point.
Real estate is much less volatile. While you can still lose money, real estate historically has been much more stable an asset class than stocks. Because of that, it’s possible and common to leverage. In my case, as an owner-occupier, I put down $12,500 to control a $250,000 asset. I am leveraged at 20:1 or 95%. While this creates risk for me, it also allows my work to have a far greater impact. Putting in the work to improve my property’s value 5% is worth thousands of dollars to me. Improving the return on a $12,500 stock investment by 5% is worth just $625. A vast difference.
There is nothing inherently wrong with investing in stocks. Buying a little bit of Apple, Google, Facebook, or anything else doesn’t make you a fool. It’s fun to talk about and buy the big names, and heaven knows that people do far more foolish stuff with their money.
The foolish thing isn’t in buying individual stocks. It’s in thinking long and hard about investing in individual stocks and spending valuable time trying to pick the winners. Expending that thought, doing large amounts of research, and attempting to earn outsized returns is an enormously difficult and emotional task. Even if you are in the tiny minority of folks who succeed, you won’t reap the benefits of your expertise until you have well over a million dollars to invest.
Forget about it. Put your intellect, education, and your back into something more tangible.
Like real estate.
Are you weighing your options and choosing where to invest your money? Do you have experience investing in real estate, stocks — or both?
Let me know your stories, opinions, tips and input in the comments section below!