Saturday, April 17, 2010

What is better stocks or real estate?

First of all, real estate is not necessarily a better investment than the stock market or bonds and visa versa. It all depends on the specific investment opportunity. People should invest in all these asset or investment classes. When one class is doing poorly another may perform better. Also, what all these investments have in common is that they are long term investments.

One should not advocate day trading or flipping houses in general. This is risky speculation rather than investing. I cannot tell you why others invest in real estate or stocks, however, for me, the reason to invest in all these investment classes is obvious: risk mitigation or as many would call it: diversification. You just don't want to put all your eggs in one basket.

Real estate investments have different characteristics than stock investing. For starters there is more work and control involved. Even for passive JV investors, the involvement with a real estate JV is more than with most stock investments and so are the risks. Some of the different investment characteristics.

Real estate lets you leverage your investment because it is less volatile. In fact you can control the volatility of your investment by determining your amount of leverage (LTV). The higher the LTV the higher the risk that your equity in the investment goes up and down as an amplified response to changes in the property value. Also, the amount of leverage is an important tool in determining the ratio of cash flow, mortgage pay down and appreciation components of your return on investment.

When investing in stocks, the opposite happens. First of all you are not in control - for all practical purposes you just rent out your money. On the other hand the investment is very liquid, you can sell it typically in a matter of hours and days. Share prices are more volatile and therefore the risk of using leverage is much higher and can result in financial disaster. Why is this? Well simple - the business you invest in is already leveraged - i.e. corporate debt. Both real estate and stock market investments are leveraged. But in the case of real estate the investor is the borrower and he/she is liable for repayment, while in the stock market the corporate loans are secured against the corporation and the corporation is liable for the loan.

So a true diversified investor does use both paper securities and real estate for purposes of asset allocation. Is Gold better than stocks? Are options better than bonds? Are commodities the place to be? It does not matter; in a properly allocated portfolio you want them all - provided you take the time to understand these investment classes.

This is key; many of us are lazy and only go into real estate or we only go into stocks. Well in doing so we are limiting ourselves and our potential to profit. Also, we increase our investment risk. This is fine; it is entirely your decision. But, you are also responsible for the outcome. Not your realtor, not your financial planner, not your banker or mortgage broker, not your lawyer or the stock broker, it is YOU who is responsible for your investment performance. You are the captain of your investment ship, all others just advice (poorly or wisely).

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