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I strongly believe that residential real estate is a bad investment. I just think that most people underestimate the cost of buying, owning, and maintaining a home and fail to take those sizable costs into consideration when calculating their total return.
factor in your time, the headaches and the stress that home ownership can cause. And it's just hard for me to make a good case for this asset class. My wife is well aware of my feelings about real estate. And while on a long drive recently, she decided to dig a little deeper and she asked to learn more about why I thought real estate was such a bad investment. You see, she has some good friends who primarily invest in real estate and they often share with her what a great investment it's been. In fact, they tell her that they're
actively trying to save more money so that they can buy more real estate. What am I missing? She asked, why do you feel like it's such a bad investment? While others I know suggest that it's the best investment they've ever made.
Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte. And today I'm talking about evaluating our investments, what separates a good investment from a bad one, and why some very well-known performance metrics and formulas are problematic. To grab the links and resources mentioned in today's episode, just head over to youstaywealthy.com forward slash 191.
Warren Buffett didn't achieve billionaire status until the age of 56. In fact, 99% of his current net worth was earned after his 50th birthday. Successful investing requires time and patience. It also requires conviction and commitment.
Buffett is one of the most successful investors in history because he adopted an investment philosophy that he believed in and he stayed the course. He didn't chase investment fads or jump from one hot stock to another in hopes that he would time the trade perfectly. His approach is to buy stocks at a good price and hold them for long periods of time. For example, he started buying shares of Coca-Cola in 1988.
35 years later, Berkshire Hathaway's $25 billion stake in the beverage company now accounts for 9% of all outstanding shares. When my wife brought up the topic of real estate investing in the car and asked me why it was such a bad investment, to my surprise, I didn't go into defense mode. I didn't try to defend my thesis with data and numbers and attempt to convince her that I was right and those who disagreed with me were wrong.
Instead, I found myself focusing on the words bad investment, calling real estate a bad investment just seemed to strike a different chord when she said it out loud. And it led me to share with her one of my favorite investing quotes that I've repeated a lot here on the podcast lately. And that is the best investment or the best investment philosophy is the one that you can stick with.
Instead of talking about all the reasons why I thought real estate was a bad investment, I started by sharing with her why it might actually be a good investment. I shared that one of the hidden benefits of investing in real estate is that it's illiquid, i.e. you can't turn on your computer and sell your house tomorrow with a few mouse clicks like you can with stocks and bonds. And for that reason, it incentivizes longer term holding periods. And that's a huge positive.
Long-term investors like Buffett on average have more success than short-term. I also shared that the definition of best investment is of course subjective. It's also personal and unique to the investor. For example, contrary to what you might be thinking right now, my wife and I own a home. By most measures, it's a nice home in a nice neighborhood that represents a fairly large percentage of our net worth.
I didn't agree to sink our life savings into this asset because I think it provides us with the best return on our hard-earned money, but because it provides our family with stability, access to the best public schools in the county. Our parents live 10 to 20 minutes away, and we don't have to live with the risk of our home being sold by our landlord, forcing us to relocate with three young kids at an inopportune time.
For me and my family and our unique goals and values, those somewhat hidden or intangible benefits actually make my home a great investment. They provide a return on life far greater than an S&P 500 index fund that might technically have higher future expected returns.
Contrary to what we might tell ourselves, our friends or our spouses, I'd argue that most investors are not focused on achieving the highest rate of return possible when evaluating and choosing investments. My wife's real estate investor friends, for example, they likely have other reasons for investing in that asset class, even if those reasons aren't documented in their financial plan or their investment policy statement. For one, it might be what they know and what they're comfortable with.
It's not comforting to invest in something that you don't understand. So investing in real estate, something physical that they can see, touch and understand, it might give them peace of mind and help them sleep better at night. I mean, what sort of price tag or premium might you place on feeling comfortable with how and where your money is invested?
It's also possible that they might enjoy owning properties across the country because they don't want to live in one house 365 days per year. They might place a lot of value on being able to move around to different cities and stay in a property that they own when they do.
Or they might have an expertise in maximizing the return on real estate. You can absolutely earn competitive returns in real estate, but like most things in life, it takes a lot of work. Your average homeowner doesn't have the skill or the time to find, buy, improve, manage, and maintain a complex asset like real estate. You can't just buy a house, hire a property manager, sit back and expect to clip 10% each year.
But if it's your passion and you've developed the skills and you have the time to dedicate, it's very possible to achieve above average returns. Too often, I think we get stuck thinking about and talking about the best investments too literally, myself included.
But what makes something a good investment? What separates a good investment from a great investment? Well, some might say that the best investment is the one that's had the highest historical returns. But we, of course, have to remind ourselves that past performance doesn't guarantee future results. Historical performance, yes, can be one helpful marker to use when evaluating an investment, but there are other metrics that should be included as well.
For example, the performance of an investment doesn't take risk into consideration. An investment may have produced the highest historical return, but how much risk was required in order to earn that return?
With that in mind, we might then find ourselves defining the best investment by the one that's had or is expected to have the best risk-adjusted returns. And while risk-adjusted returns are another important factor to take into consideration and certainly an improvement from just looking at performance, this approach also has flaws.
For example, a popular financial metric for measuring the relative risk adjusted return is known as the Sharpe ratio. The Sharpe ratio can be calculated on any given investment or portfolio. And just to keep things extra simple here, the higher the Sharpe ratio, the better. A higher Sharpe ratio indicates that an investment has a better relative risk adjusted performance.
But again, while the Sharpe ratio can be helpful and can be one metric to lean on in your analysis, it also has flaws that may not necessarily lead us to identifying the best investment. For example, let's look at three different funds and their respective Sharpe ratios from January 1st, 2000 to June 30th, 2023. So the last 23 years, fund number one had a Sharpe ratio of 0.59%.
Fund number two had a Sharpe ratio of 0.48 and fund number three had a Sharpe ratio of 0.40. Based on what I just shared about using the Sharpe ratio to identify the investment with the best risk adjusted return, we would quickly go ahead and say that fund number one is the best because it has the highest Sharpe ratio.
But now let's reveal the funds and look at some other performance metrics during this same time period. So fund number one, the fund with the highest Sharpe ratio was the Vanguard Total Bond Market Index Fund. It had a 4% standard deviation, which is a measure of risk and volatility, and it had a 4% average annual return during this 23-year time period.
Fund number two was the Dimensional Small Cap Value Fund. This had a 22% standard deviation, so higher risk, and it had a 10% average annual rate of return during this time period. Fund number three was the S&P 500 represented by the SPDR ETF SPY. It had a 15.5% standard deviation during this time period and a 6.75% average annual return.
So I'll go through that one more time. Fund number one, the one with the highest Sharpe ratio had a 4% average annual return, 4% standard deviation. Fund number two was your small cap value fund. It had more risk, 22% standard deviation, but a higher return, 10% average annual rate of return during that time period. And then finally, the S&P 500 was fund number three, 15.5% standard deviation, 6.75% average annual rate of return.
It's hopefully pretty clear that measuring risk-adjusted returns using something like the Sharpe ratio is problematic and flawed and not always useful to your average investor. The Vanguard Total Bond Market Fund had the highest Sharpe ratio because it had the lowest risk as measured by the standard deviation. But lower risk, as illustrated by the historical performance there, means lower returns.
And that might be considered good for investors targeting capital preservation, but it might be considered bad for those investors looking for long-term growth.
In addition to getting caught thinking about the best investment too literally and getting hyper-focused on a handful of metrics, we also have to avoid evaluating investments in isolation. If you type in the best investment into Google, you're going to find hundreds, thousands of articles listing investments that the author is suggesting are the best. Everything from T-bills and high dividend stocks to crypto and real estate.
But instead of evaluating investments in isolation, I'd suggest that it's more prudent and more beneficial for retirement investors to measure how investments behave and perform together in a diversified portfolio. For example, if you compare in isolation corporate bonds to government bonds, you might conclude that corporate bonds are the better investment.
But if you compare each of them as part of a diversified portfolio, you'll likely come to a different conclusion. I've referenced it in the past, but I'll link to a couple of research papers in today's show notes if you're interested to learn more.
The other benefit to evaluating investments as part of a diversified portfolio is that the diversification benefits typically improve the behavior gap. IE, a properly diversified portfolio has proven to be easier for investors to hold on to for long periods of time, which in turn improves the investors' long-term returns.
If you buy a single investment that's too risky, you might find out that you don't have the stomach to hold onto it through all the ups and downs in order to reap the long-term benefits. Alternatively, you might choose a low-risk investment and begin to feel like all of a sudden you're missing out on higher returns elsewhere, causing you to bail and try something riskier.
The primary reason that I'm an advocate for including small cap stocks, value stocks, international stocks, and AAA rated government bonds as part of a globally diversified portfolio for those who are nearing retirement or in retirement is not because I think it's a superior approach to portfolio construction that will produce the best possible returns.
but because of the diversification benefits it provides. The recent episodes I've published on international stocks and the last decade are great examples. In retirement, when we're relying on our investments to produce a paycheck, we don't want everything in our portfolio moving in the same direction. Most people can't afford to go through a 10-year time period of negative returns like the US stock market produced from 2000 to 2009. Most people would also struggle to stay committed to their investment plan as well.
While it's not confirmed, there's an often-referenced story suggesting that Fidelity once examined all of the investment accounts on their platform to identify which accounts had the best performance and why. The conclusion was that the best-performing accounts were owned by those who forgot they had them.
The best investment does not exist. The best investment or the best investment portfolio is the one that you can stick with, even if sticking with it means that you forgot it existed. The best investment is also the one that aligns with you, your goals, your values, and your needs. So through this conversation with my wife and my time preparing this episode, I've realized that I sometimes get caught painting with too broad of a brush when giving my opinion about different asset classes.
Real estate is not a bad investment. Setting my primary home aside, I don't believe that real estate is a good investment for me, my goals, and my investment philosophy, but it could very well be a great investment for someone else. So I'm curious, how do you evaluate your portfolio? What do you think separates a good investment from a bad one?
What investments do you own that on paper might lead someone to conclude that it's a bad investment, but you have other personal reasons for maintaining it?
I'd love to hear from you. Shoot me an email at taylor at youstaywealthy.com and share your thoughts. Once again, to grab the links and resources mentioned in today's episode, just head over to youstaywealthy.com forward slash 191. Thank you as always for listening, and I'll see you back here next week. This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.
