Battle of the Investments: Stocks, Bonds, and Real Estate
Stocks, bonds, and real estate—oh, my!
These are the three main classes of investments.
You may notice the absence of gold and Bitcoin. Gold actually has poor inflation-adjusted returns over time, and cryptocurrencies are too new to have established a track record across different types of market conditions.
Plus, one thing that gold and Bitcoin have in common is that they’re unproductive assets. You buy them and they just...sit there.
Stocks, however, represent partial ownership in a business. That business is [presumably] a productive enterprise that generates money by selling a product or service that people will pay for.
Bonds are loans to businesses and governments. The business or government entity uses the money to make improvements, which is [presumably] an efficient—and value-generating—use of that money.
Real estate provides installments of cash on a regular basis, because people need space to live, work, and store stuff. They will therefore make periodic payments to accommodate that need.
You’ll notice that stocks, bonds, and real estate are alike in that they actually do something to provide value to people.
Gold has some industrial uses, but its main uses have always been as 1) a store of value, and 2) a way to show off one’s wealth. Bitcoin has many aspects, but it’s best thought of as an experiment in deregulated currency.
You probably wouldn’t trade your money for a bunch of rupees, expecting it to rocket upward in value relative to the U.S. dollar. And India is an actual country with well over a billion people, people who live and work and buy stuff. And pay taxes. And have a military.
So why would you trade your money for a bunch of Bitcoin, expecting it to rocket upward in value relative to the U.S. dollar? Especially when it’s not guaranteed by a government, or tax revenue, or military force? Or supported by actual useful work?
Due to that reasoning, I’ve deliberately excluded nonproductive assets like precious metals (gold, silver, platinum) or cryptocurrency (Bitcoin, Ethereum, Ripple) from this analysis.
Remember also that a wise investor is concerned not only with rate of return, but also with preservation of one’s principal.
So let’s get started.
Bonds
Generally the least volatile of the Big Three investments, bonds are generally seen as boring.
It’s true that they tend to have relatively mild price movements—either up or down—and tend to have a reasonably steady return as they draw closer to their maturities. As such, they’ve been called stodgy investments.
But that’s not necessarily a bad thing, as illustrated by the story of the tortoise and the hare.
Since 1972, an index fund holding various bonds would have returned 6.72%. At this rate, a $100 investment in bonds would turn into $2268 by 2019. Not bad!
Data source: Paul Merriman Fine Tuning Tables
Real Estate
Real estate is a popular but misunderstood investment vehicle.
Fact: There are tax advantages to owning a property.
[Note that there are also tax advantages for other investment vehicles, like holding stocks or bonds in a 401(k) or IRA.]
Fact: You can buy properties at bargain prices sometimes, such as foreclosures, and therefore make a better return on investment.
[Note that there are also times when you can purchase stocks or bonds at a deep discount.]
Fact: People will always need space. Thus, there will always be demand for real estate.
Fact: There’s only a [relatively] fixed amount of land. Thus, there’s a fixed supply of real estate, and as noted above, there will always be demand for it.
Though all of the above statements are true, property ownership isn’t all roses and fun and jumping into piles of money to make snow angels. [Err...money angels?]
I’ve heard people make impassioned cases about why real estate is the best investment vehicle, but those same people usually highlight all the advantages while glossing over the disadvantages. Here are some less-convenient facts:
Fact: The quality of a particular property is subject to factors outside a landlord’s control. A local government spends itself into a hole and decides to raise property taxes? A massive sewage spill contaminates the area? A large employer moves elsewhere?
There’s nothing you, as a property owner, can do about any of these. But each could damage the value of the property, perhaps irreparably.
Fact: Even the highest-quality property requires
regular maintenance. Which means you can expect to be fixing something almost constantly:
- Mowing
the lawn or shoveling snow.
- Repairing
or replacing piping.
- Remodeling
to suit the trends of the moment.
- Dealing
with a toilet that just refuses to flush.
- Replacing the roof. Or the furnace. Or the A/C.
Just look up the cost of a brand-new furnace. Yikes!
Ownership can be rewarding, but it can also be a pain in the rear.
Fact: Interest rates have, as a general trend, been falling since the 1980s. Falling interest rates mean people will pay more to buy a home. That’s a great trend for property values!
But the flip side is that interest rates have recently been about as low as they can go. When interest rates rise, as the Fed is doing in 2022, a lot of people will see their home values drop.
Fact: People rarely have enough money to buy a property outright. And that includes many landlords.
A mortgage generally has lower rates and longer terms than other loans, and the mortgage is backed by a piece of physical property that will maintain some value. So a mortgage is a ‘better’ loan than most other loans.
But make no mistake—it’s still debt. And, as with any type of debt, it can wipe you out if things go wrong. See the above note about interest rates.
If you take out a mortgage for a $250,000 house, you’re counting on the property holding that value. But if something happens where you have to sell the property, and interest rates have just now risen—meaning that nobody will pay $250,000 for it anymore—you could end up owing more on that property than you can get from a sale!
Fact: That reminds me: the fees! There are mortgage origination fees, realtor commissions, taxes…it’s expensive to buy or sell a home! And, just like with home maintenance, you can either do it yourself (which takes time, effort, skill and a little money) or you can hire it out to an expert (which takes a lot of money. As well as the frustration of finding a good one).
So real estate, like any type of investment, has both risks and rewards.
If you prefer a more passive and lower-risk approach to real estate, you can put up the money while delegating the daily tasks to professionals. I’m talking about REITs, or real estate investment trusts.
This investment vehicle has a unique legal treatment. It is federal law that a REIT must pay at least 90% of its profits to investors. These dividends are then taxed, unless the REIT is held in a tax-advantaged account, like a 401(k), IRA, or TSP.
So, you might be wondering how REITs have fared, historically.
Between 1972 and 2019, REITs appreciated at an average of 9.77% per year. A $100 investment in 1972 would end up being worth $8778 by the end of 2019. Pretty good!
Data source: NAREIT
Stocks
If you’ve ever watched the financial news, you could be forgiven for mistaking the stock market for a casino.
{After a strong morning, the S&P ended the day
down six-tenths of a percent.}
{In a wild day on Wall Street, the Dow was up 1.3%
at the close…}
{Investors are worried by growing tensions in the Middle East and rumors of tax rate changes by the federal government, leading to a tough day on Wall Street as the Dow drops over seven hundred points...}
But don’t be fooled by the talking heads. That stuff doesn’t matter unless you’re a day trader. And trying to routinely time the market is a dangerous game…
Instead, think of it as a long-term ownership scenario. If you’re a stockholder, you do indeed have a small fraction of ownership in that business.
Would you own a business and then sell it after only a few hours? Or a couple days?
Of course not! So think of stocks the same way—temporary fluctuations aren’t important; it’s the long haul that matters.
Since 1972, large-cap stocks (as represented by the S&P 500) returned an average of 10.66% annually. Over this timeframe, a $100 investment in the S&P 500 would grow to just over $12,900. Wow!
Data source: Paul Merriman 4-Fund Combo Relative Rankings Performance Chart
The winner
To recap: between 1972 and 2019, $100 in bonds would grow to over $2250.
That same $100 in REITs would grow to almost $8800 during the same time.
And that same, crisp $100 bill, invested in the S&P 500 in 1972, would have been worth nearly $13,000 by December of 2019!
The ultimate winner? Stocks.
The caveat
Past performance is no guarantee of future returns. Billionaire investor Cliff Asness pounds that point home in an academically-dense paper called “The Long Run Is Lying to You.”
And the time period since 1972 has included some pretty long bull markets. If you look at a different time period, the results may well have been different.
In fact, if you look at only the data from 1990 through 2019, REITs actually emerge as the winner! On average, REITs returned 10.94% per year, vs. 10.08% per year for the S&P 500.
But for the purposes of this analysis, we’re looking at a very long period of time.
REMEMBER: each asset class had years with negative returns and years with impressive, double-digit percentage gains.
Investing is a long game. Over a long enough time horizon, there will
be bad years. There will be good years. And there will be years where the
market remains pretty much flat. Come to terms with that before you put
money into the market.
For what it’s worth, the data I could find for REITs only goes back to 1972. I have information on bonds going back to 1970, and I have data for various types of stocks dating back to 1928!
But, of course, we want an apples-to-apples comparison. So, to keep things fair, I have to use the latest starting date available—and that’s REITs, starting in 1972.
Can I guarantee what will do best over the next 50 years? No, of course not! I'm just some random blogger.
But I can provide information about what happened in the past. We can use that information to try to project what is likely to happen in the future.
And, for what it’s worth, I’d recommend holding some of each.
I can hear some readers asking, why hold bonds? They’ll just put a
drag on my performance!
That’s true mathematically, but I’ve listened and learned from the wizened old veterans of investing. And they counsel prudence.
Consider a hypothetical person—let’s call him Frank—who put all of his investment money into 500 of the largest publicly traded companies in January 1928. According to the common wisdom at the time, he would have been extremely well-diversified. [Back then, twenty or thirty stocks was considered sufficient diversification, as long as they weren't all in the same industry!]
But by the depths of the depression in 1932, Frank would have lost around 50% of his original investment, and over 65% of the peak value of his holdings!
What kind of psychological effect do you think that kind of loss would have on poor Frank? Would his reaction resemble Option A or Option B?
Option A: Cheerfully say, “Things can’t get much worse! I’ll plow my extra cash back into the market, and it’ll recover eventually!”
Option B: Pull out whatever money he had left, and swear off stocks for the rest of his life!
History shows that, by the end of 1938, Frank would have made a hefty profit if he had chosen Option A.
But history also shows that almost everybody chose Option B.
Loss aversion is a real—and powerful—psychological phenomenon. Many experts decry loss aversion as a foolish and illogical reaction to a temporary setback.
But the fact is, loss aversion served an evolutionary purpose throughout humanity’s history. To speak colloquially, it prompts us to carefully evaluate the possible costs of an action.
To illustrate: it might be worthwhile to rush into a burning building to rescue your spouse or child. It is not worthwhile to rush into that fiery inferno to save your favorite recliner.
Because such psychological factors often work against us in the investment world, we need to adopt an approach that will allow us to sleep at night. Which means holding a variety of assets that won’t go down at the same time.
The best investment for a robot would probably be a small-cap value fund. But, for actual humans who are afraid to lose money, it might be better to hold a little bit of everything.
And I have some good news! You can accomplish that with only one fund: a target-date retirement fund. Such funds hold stocks (both domestic and international), bonds (domestic and international), and most have a little exposure to REITs as well.
I have more good news: financial educator Paul Merriman and his colleagues suggest a simple two-fund approach, called “2 Funds for Life.” This consists of a target-date retirement fund, plus a low-cost index fund that holds small-cap value stocks. Merriman and his colleagues say that the decision to add small-cap value could, over the course of your lifetime, be a million-dollar decision!
Why didn’t I just tell you that from the beginning? Well, when the market’s down, you won’t stick to the plan unless we can teach you something about investing.
Consider yourself better-informed.
___
Check out my book-review series, available now:
1. Debt: The First 5000 Years by David Graeber
2. Rich Dad Poor Dad by Robert Kiyosaki
3. The Clash of the Cultures by John C. Bogle
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