Monday, February 15, 2010

Stock Market? or Real Estate?

This article is written by my good friend Joe Gibson, President of the Carolinas Real Estate Investors Association:

I was at a Christmas party with good friends who are also investors. The question arose: what to do with the money in the stock market? We had discussed this question before but never arrived at a good answer, which to me means an answer supported by sound reasoning.

Within weeks of having this conversation, I came across several articles that provided the reasoning. One article listed the 5 best performing mutual funds in the world for the last decade, another listed the mutual funds that had out performed the S&P 500 every year, and the last analyzed the volatility of the stock market in the last 15 years (links to the articles are at the end of this blog). The S&P 500 is composed of the 500 largest companies, is weighted by capitalization and is a common measure of stock market performance.

The 5 best performing mutual funds in the world for the last decade and their returns are:
1) East Capital Ryssland – 1,524% or 131% per year
2) Russian HQ Ryssland – 962% or 125.4% per year
3) FIM Russia – 906% or 124.7% per year
4) Baring Russia – 839% or 123.7% per year
5) Odin Maritime – 832% or 123.6% per year

Those are pretty good returns. Let’s take the best one. A 1524% return over 10 years means that if you had initially invested $10,000 you would now have $152,400 or you would have an average profit each year of $15,240. As a side note, I don’t think these funds are readily available to the average investor in the US.

Now let’s take a look at US Equity funds. There are around 8,000 mutual funds in the US. Guess how many of them have out performed the S&P 500 every year since 1999? If you guessed more than 1, you would be wrong. Now guess how many have done it every year since 2000. The answer is 7 and 2 of those have a minimum investment of $250,000 and 2 have a minimum of $1M. Think about that for a minute. Only 7 funds out of around 8,000 total mutual funds or 0.0875% have out performed the S&P 500 every year since 2000. How does the average investor make a decision with those kinds of odds?

In the last 10 years the return of the S&P 500 Index has been -0.78%. That’s right, it is negative! If you had invested $10,000 ten years ago today you would have about $9,922. If you had put your money in a money market account at any positive interest rate for the last 10 years you would have outperformed the S&P 500.

The 3rd article looked at the S&P 500 Index over the last 60 years. The conclusion is that for the first 45 years there was little volatility and an average 10% growth rate. When you hear people talk about stock market investing they commonly refer to an average growth of 10%. This is the source. However, the last 15 years has been a period of extreme volatility. There have been 2 periods with losses of 46% and 56%. Keep in mind that if the market drops 50% you need a 100% increase to get back to your starting point.

The conclusions I draw from the last 2 articles is that it is difficult to outperform the market in general, it is difficult to pick funds out of the 8,000 available that will outperform the market, and that we are in a period of high volatility in the stock market. If the professionals have these difficulties, what chance does the average person have?

Let’s take a look at the returns from real estate and compare it to the best performing fund of the last 10 years. What would you have to do in real estate to take $10,000 and make $15,240 per year? Is it possible? Do you think you could do that?

Here are 2 strategies that would meet or beat the best returning mutual fund of the last 10 years. I am sure there are others.

Strategy 1
If you did 5 wholesale real estate deals a year and made $3,050 per deal that would equal $15,240 which matches the best performing fund. You could probably do it with a lot less than $10,000 so your return would be higher. Let’s assume you started with $1,000. That is a one year return of 1524% versus the fund’s average annual return of 131%.

Strategy 2
Buy and flip 1 house a year and clear a minimum of $15,240. This is more work than strategy one, requires more knowledge, and may have higher cash returns. You would take the $10,000 and use it for the down payment, rehab costs, etc. Depending on the deal and how it is structured you may not need any additional money. If you did need more cash you could use a private investor or other financing.

My friends do a lot of deals with doublewide mobile homes. It is not uncommon to buy them for $15 - $20,000, put $5,000 or so into it and sell it for $60 - $90,000. So, making $15,000 on a doublewide is very doable.

Why should you be able to get better returns in real estate than you can investing in stocks or mutual funds? I think it boils down to 2 factors:
1) source of information/knowledge that is the basis for decisions
2) security of your investment

Information for decision making
With stocks/mutual funds the decisions are typically based on advice from a financial advisor, a report by an analyst, information released by the company, or general news stories. It is very difficult for an individual to get the complete, unbiased story in order to make a decision. There is a great deal of information needed to make good decisions and much of it is not readily available. Given the returns that most of the professionals generate, it seems they have a hard time getting the story right also.

With real estate investing you can learn a market, history of recent sales, market trends, zoning, etc. that allows you to make an informed decision and allows you to calculate, with some degree of confidence, your return. With real estate, you have greater control over the possible returns because of the knowledge you have or can gain and the work you put into the project. This is not possible with stocks or mutual funds.

Security of your investment
With stocks or mutual funds there are no tangible assets backing your investment. When you buy a stock you don’t own a piece of equipment or a building or anything tangible. You can lose all of your investment quickly and you have little to no say on the decisions the company makes that can affect your investment.

With a real estate investment you have a piece of property that backs up your investment. Done correctly, your investment is a percentage of the value of the property meaning that you have equity. For example, the property may have a market value of $80,000 and your total investment is $50,000. The property could lose $30,000 and you would still break even. There is a margin for error that does not exist with stocks/mutual funds.

It is pretty clear to me that it is possible to earn much better returns with real estate than with mutual funds. Personally, I have been making the shift from the stock market to real estate with the money in my IRA. The major requirement is that you first invest in your knowledge so that you make better decisions concerning real estate investments. With the proper knowledge you can earn good returns investing in real estate, returns that exceed what you would earn in the stock market.

Links to Top Mutual Funds Worldwide,1498909

Mutual Funds that out perform S&P 500

S&P 500 Volatility,1498909

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