In over 20 years of investing in equities (stocks) and real estate, I have often heard it said that stocks lead to the best return on your money out of all of the asset classes available to the average investor. The so-called experts like to quote statistics showing that stocks have had an average yearly gain of 8 percent over the last 70 plus years. And because that is far higher than the average gain of any other asset class, including real estate, it is obvious that stocks are the most profitable asset class to invest in. Right?
However, the math is not that simple. Their logic sounds good, while in truth, they are not making a like comparison. It is true that stocks have returned an average of around 8% per year since World War II. In that time, real estate’s returns have varied depending on where in the country it is located. However, depending on where you look for your data (National Association of Realtors, US Census, Case-Schiller Index, etc) the average yearly home appreciation between 1968 and 2009 averaged between 3.4 and 5.4% (each version sites its own methodology). But when looking at stock appreciation and real estate appreciation, the formulas we use must be different.
With stocks, most average investors use all of their own money. If an investor wants to buy one hundred shares of Wynn Resorts (Wynn) at $140 per share, she will invest $14,000 in those shares (not counting commissions.) If that stock climbs 10% to $154 per share, the value of the investment will now be $15,400, which is also a 10% increase of course. So, in that situation we have a genuine 10% increase in the actual money invested. ($14,000 invested, with a profit of $1,400).
On the other hand, if that same person buys a home, she is very unlikely to pay the entire purchase price with her own money . Rather, she will probably take out a loan. Let’s say that she purchases a $250,000 home with 10% down (which is a very common down payment). That would mean that she puts down $25,000, and takes out a loan for $225,000. If that property appreciates at 3% per year (even lower than the low end of the figures above) then after one year, it would be worth $231,750. So, the value of the home has increased by $7,500 in one year. While that is 3% of the total value of the home, it is not a 3% return on her money invested. Remember, she only put down $25,000 as a down payment. So, an increase of $7,500 is a return of 30% on her invested money.
See the difference? So yes, if you are looking at average appreciation of the entire price of an investment, then stocks look better. However, most people do not purchase a home with cash. So, to truly compare returns, you must compare returns on the money actually invested. A $7,500 return on an initial investment of $25,000 is an increase on investment of 30%, on a 3% increase in total price. Whereas, because most people do pay cash for stocks, the return is figured differently. A $1,400 return on an investment of $14,000 is a 10% return on a 10% increase in price.
Does this mean that real estate investing is better than stock investing? No. They are just different, and it is important to truly understand the math. I am a fan of investing in many types of assets. So, I am not taking a side here. I just want to clear up a very common misconception. It is also important to know that the exaggerated returns made possible by using the bank’s money for real estate, can also work against you. Going back to our examples. If our investor purchased the same amount of Wynn stock at $140 per share and it dropped to $126 per share, she would have lost 10% of her money from the 10% price drop. If the house she purchased for $250,000 dropped to $242,500 (a drop of 3% on the purchase price) she would have lost 30% of her money invested ($7,500 divided by $25,000 invested).
So there you go. It’s a common misunderstanding, but an important one. Knowing how to properly figure returns is a crucial part of deciding where to put your money. And as always, it is important to choose the investments that best suit your needs, but at least now you know how to accurately compare your results.
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