Archive for November, 2010

10-, 20- and 30-Year Stock Returns

I found a blog post with three interesting charts.  The first chart shows the 10-year return of owning the S&P 500 stocks and reinvesting dividends.  The second and third charts repeat this for 20-year and 30-year periods.

Over the last ten years, your annualized return would be a loss (-1.86%).  Over the last twenty years, your annualized return would be +6.38%.

This is the link to that blog post.

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Tuesday, November 30th, 2010 Stocks Comments Off on 10-, 20- and 30-Year Stock Returns

Smackdown: Stocks vs. Gold vs. Housing

In a previous post, we examined the performance of single-family Home values relative to Stocks and various Commodities.  What about a direct comparison of the investment performance of Stocks, Gold and Housing?

The chart below examines the performance of these investments over the last twenty years.  The Stocks (S&P 500) graph does not include reinvesting dividends.  The red line plots Stocks (the S&P 500 index).  The pink line plots residential Housing (the Case-Schiller index).  The gold line plots Gold, and the black line plots a “Balanced Portfolio” consisting of one-third each of Stocks, Gold and single-family Housing.  If I had included reinvesting dividends, Stocks would have performed better.
Investment Performance
As you can see, both Stocks and Gold would have increased about 350%.  Housing would have increased about 200%.  The Balanced Portfolio did pretty well (at 300%) and was less volatile.

Here is the same data adjusted for inflation (using the CPI):
Investment Performance Adjusted For Inflation
I chose the last twenty years because this is about as long as many people hold investments before retirement.  These charts assume that you invested a lump sum of money in 1990.  The performance of an investment really does depend upon when you invest your money.  That’s why financial planners recommend that you invest monthly to “dollar cost average” the money you invest.

What if you had a time machine and could go back in time to invest a lump sum of money?  What would you invest in?  Which investment is best depends upon how far back in time you travel.  The chart below shows the best investment depending upon which year you invested your money.
Lump Sum Investment Required in Specific Year
This chart shows how much money you would have had to invest in order to have $100,000 in 2010.  If you only traveled back to 2006, you would have had to invest more than $100K in Housing or Stocks to have $100K today.  You need to travel back in time to a year where the graph dips lower so that less money is required for investment.  The lower a line dips, the better the time to invest.

If you traveled back to 1990, you could have put your money in either Stocks or Gold (a little under $30K ) to grow to $100K in 2010.  The first chart also shows this equivalence.

In 1999, you wouldn’t want to invest in Stocks, because that was a peak in the market and you would need to invest $125K to end up with only $100K.  1997 to 2003 would have been a great time to invest in Gold.

At no time was single-family Housing the best place to invest (the lowest line).  In fact, there were only twelve years that Housing wasn’t the worst place to invest.  Remember, this is a “buy low” chart; it tells you when you can buy lowest.

The Case-Schiller home price index averages twenty large cities.  There are certainly some cities where home prices have performed better.  There are also some stocks that have performed better than the S&P 500 index.

Just because the house you live in has under-performed as an investment, doesn’t mean that all real estate is a bad investment.  Many people have had good success investing in income-producing property such as apartment buildings, office buildings, etc.  Income producing property has a more rational valuation method than does single-family housing.  Just as the value of stocks is roughly based on the earnings of the stock’s company, income-producing property is roughly valued on the annual rent it produces.  There is a “price-to-earnings ratio” for stocks and a “gross rent multiplier” for income property.  Buying income property is a business decision, buying the house you live in is usually an emotional decision.

So what is the bottom line of the previous charts?  I think one conclusion is “You shouldn’t have most of your assets tied up in the house you live in.”  Also worth noting is that for the last nineteen years, Gold has been the best investment.  For ten of those nineteen years, Stocks were the worst place to invest a lump sum.

The Balanced Portfolio is one-third each Stocks, Gold and Housing.  Some financial advisors suggest that you have ten percent of your portfolio in Gold.  Is ten percent enough to diversify a portfolio?

Let’s see how four different diversified portfolios performed over the last twenty years.  The chart below shows our Balanced Portfolio in black.  A portfolio with only ten percent Gold and forty-five percent each Stocks and Housing is shown in gold.  A portfolio with ten percent Stocks and forty-five percent each in Gold and Housing is shown in red.  And a portfolio with ten percent Housing and forty-five percent each in Gold and Stocks is shown in pink.
Four Diversified Portfolios
It’s obvious that the worst performance is the portfolio that only has only ten percent in Stocks, the red line.

The portfolio that is only ten percent Gold performs best until 2008 when both Stocks and Housing are in decline and Gold starts to take off.

The portfolio that is only ten percent Housing performs second best until 2009 when it takes off and is the best performer.

This chart indicates that the most important part of your portfolio is Stocks.  If at least one-third of your portfolio is in Stocks, you would have done OK.  The two portfolios that had forty-five percent in Stocks (gold and pink lines) generally did the best.

So what kinds of stocks are best?  And what about bonds?  Maybe we will discuss those topics in another post.

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Friday, November 19th, 2010 Gold, Real Estate, Stocks 1 Comment

Buying Your House on Margin

Buying stocks “on margin” means that you don’t have enough money in your investment account to buy the stocks, so you have to borrow the money from your broker to make the purchase.  You have to pay interest on this money, of course.  Buying stocks on margin is considered to be very risky.  It is a technique that is sometimes used by “traders” but not by “investors.”  Even the risk-takers wouldn’t hold stocks bought on margin for a long time.

Why do traders buy on margin?  Because it is leverage.  If you buy $1,000 worth of stocks and you only put up $100 of your own money and borrow $900, you are leveraged.  If the value of the stocks goes up 10% to $1,100, you can sell the stocks, pay off your $900 margin loan and have $200 left.  You started with $100 and now have $200 for a 100% profit on a 10% stock value increase.

So why is buying stocks on margin risky?  Because stocks don’t go straight up in price.  As we all know, stocks go up and down daily.  If your stocks go down 10% in value to $900, and you have to sell, you only have enough to pay off your $900 margin loan.  You have lost your original $100 which was all of your money – A 100% loss.  Buying on margin is betting that the stock will go up rather quickly so you can make your profit and then sell to get rid of your risk.

When you buy a house with a mortgage, you are buying the house on margin.  This is the key to making money in real estate – leverage.  So if buying stocks on margin for a short period is considered risky, why is buying a house on margin for thirty years considered a conservative investment?

Borrowing to buy real estate is a conservative investment because real estate always goes up in value.  You never have to worry about your house losing value.  Really, they aren’t making any more land, an increasing population keeps needing more housing; what could go wrong?

The housing bubble could pop; that’s what could go wrong.  Just like “dot com” companies in the 1990’s, anything can become overvalued and must eventually correct.

Here is a chart of house prices since 1950 (the Case-Schiller index):

House Prices

Buying a house on margin would have been a good investment if you bought and sold before 1990.  If you bought after 1990 you would have to wait to sell between 1999 and 2006 to come out ahead.  If you bought since 2004, your house has probably lost value, and you will have to wait several more years before breaking even.

Some families who have bought houses in the last five years have discovered that their homes are worth less than the mortgage.  If they sell, they will have to come up with extra money to pay off their margin account (mortgage).  They are faced with the prospect of continuing to make loan payments on a losing investment, or defaulting on their loan and losing everything.

Here is a chart of house prices adjusted for inflation (CPI):

House Prices Adjusted For Inflation

As you can see, from 1950 until about 1985, house prices mostly kept up with inflation.  The graph has a slightly negative slope from 1954 to 1974 which means that during that period, price increases did not keep up with inflation.

Starting around 1985, housing went through two boom/bust cycles.  From 1985 until 1998, house prices increased and then came back down to where they started.  The second boom/bust cycle started in 1997 and may not have finished yet.  Remember, this is adjusted for inflation.  On the previous chart, the first boom/bust cycle isn’t as evident.

The “conservative strategy” for investing in stocks used to be “buy and hold.”  Buy stocks of good companies, hold them for ten to twenty years, and then sell them at a profit.  It didn’t really matter when you bought, as long as you held the stocks for a long time, you would make a profit.

The stock market “crash” of 2008 – 2009 has caused many investors to question this strategy.  As we will see in a later blog, you could have held stocks for a long time and still lost money — It all depends on when you bought.

The “conservative strategy” for investing in your home used to be “buy, wait and move up.”  Buy your house on margin (borrow money via a mortgage), wait five years, sell at a profit and buy a more expensive house on margin.  It didn’t matter when you bought, because real estate always went up.

The bursting of the real estate bubble has caused home owners to question this strategy, too.  You could have bought your house six years ago, sold it, and not have enough money to pay off your mortgage.  It turns out it matters when you bought your house.

With stocks, you can buy low and sell high.  With your home, if you buy a new house when prices are low, you also have to sell your old house when prices are low.  You can’t “time the market.”  You have to buy and sell during the same market conditions.

Investing in stocks has another advantage – you don’t have to buy your whole portfolio at once.  You can invest a little each month and “dollar cost average” your purchases.  You don’t have to borrow money to invest in stocks.

With a house, you can’t “dollar cost average” your investment.  You have to buy the whole house all at once.  Also, very few people can afford to pay cash; they have to borrow the money.  Interest payments add to the cost of the house.  Houses also require maintenance and property tax payments – disadvantages that stocks don’t have.

I once told my brother that I had never made much money on houses that I lived in.  He replied that it was because I actually kept track of what the houses cost me.  Most people don’t keep track of how much money they actually put into their home.

Houses have a major advantage over stocks – you can live in them.  You have to live somewhere, so why not try to make some money off of it?  This is the same argument that is made for whole-life life insurance.  If you need life insurance, why not use it as an investment?

In most cases, it is better to buy cheaper term life insurance and invest the premium difference.  You have life insurance for the years that you need it, and you end up with a larger investment portfolio.

These days, many former home owners are renting a house for less money than it costs to make mortgage payments, tax payments and maintenance costs.  They can separate their living costs from their investment purchases.

But what about the mortgage interest tax deduction?  Doesn’t being able to write off your mortgage interest on your taxes make home ownership a better investment?

If you buy a house for $200,000 with a thirty-year mortgage at 4.50%, your mortgage interest payments for the first five years will total $43,118 which is an average of $8,624 per year.  The “standard deduction” on your 1099 tax form for a married couple is $11,400.  This means that you would need another $2,776 in tax deductions (such as property tax) just to break even with the standard (no itemization) tax deduction.

Let’s say that you do break even with the standard deduction as described above.  Your monthly payment for mortgage and taxes would be $1,245.  This is probably about how much it would cost to rent the house.

So, if you want to live in a house that costs $200,000 or more, it probably makes more sense to buy it than to rent it.  If you don’t have to sell your current house, it probably makes sense to buy that new house in 2011.  Experts think the residential real estate market, in the USA, should hit bottom by the end of 2011.  Remember, you have to buy low and sell high for margin investing to work.

No investment is perfect, including real estate.  Real estate can be a pretty good investment though, and we will discuss how it compares to other investments in another blog post.

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Saturday, November 13th, 2010 Real Estate Comments Off on Buying Your House on Margin

How Much Bread is Your House Worth?

If you bought a house twenty years ago, your house would now be worth about twice what you paid for it – valued in American dollars.  But what if you valued your house in ounces of gold, or loaves of bread, or gallons of gasoline, or shares of stock?

Thinking of your house valued in something other than dollars may require a little stretching of the old brain cells.  We think of dollars as having a fixed value.  Things go up or down in price based on how many dollars it takes to buy them.  In fact, dollars don’t have a fixed value relative to the necessities of life.

Let’s say that twenty years ago you ate one Big Mac and a medium Coke for lunch at McDonalds.  Today, you would eat the same amount of food, but the price in dollars would not be the same.  Your basic need for nutrition hasn’t changed, but the number dollars required to provide the nutrition has changed.

Your house today provides the same shelter it did twenty years ago, but the number of dollars required to buy it has changed.

Housing is a basic requirement of life, but so is food.  What if your house were valued in loaves of bread?  If your house had the same value as 100,000 loaves of bread twenty years ago, what would be its value in loaves of bread today?  The answer:  about 100,000.  Selling your house to buy bread wouldn’t buy any more bread today than it would have twenty years ago.

Energy is also a basic requirement of life.  What if your house were valued in gallons of gasoline?  Today, it would only take about 80% as much gasoline to buy your house as it did twenty years ago.

Take a look at this chart.  It shows how the value of the average American home has changed over the last twenty years.  The green line is dollars; the brown line is loaves of bread; the yellow line is ounces of gold; the blue line is gallons of gasoline, and the red line is shares of the S&P500 stock index.
Housing Values

The housing boom from 1998 through 2006 is clearly illustrated by the rising green line.  The bursting of the housing bubble is shown from 2007 through 2009.

Doubling the value of your home (in dollars) over twenty years looks pretty good until you notice that the house value in bread is the same as its value in bread twenty years ago.  One way to look at this is that the rise in value of your house is entirely due to the same inflationary forces that affect the price of bread.

Your house is actually worth less today valued in gallons of gasoline.  If your net worth was stored in a tank filled with gasoline instead of a bank filled with dollars, it would be less expensive for you to buy your house now than it was in 1990.

What about gold?  Look at the gold line on the graph.  If your house cost 1,000 ounces of gold twenty years ago, it would only cost about 600 ounces of gold today.

The same goes for stocks.  If, in 1990, you put enough money into an S&P500 mutual fund to buy a house, you would only need to sell 60% of your shares today to buy that house now.  And that is without reinvesting dividends.  The chart does not take dividends into account.  During the “dot com” stock boom of the late 1990’s it would have taken even less stock to buy a house.

The purpose of this mental exercise is to point out that real estate isn’t the great investment you have been led to believe.  Sure, you get to live in your house while it appreciates, but with stocks you get to receive dividends as they appreciate.  And real estate doesn’t always go up in value; just look at the green line (based on the Case-Schiller housing index).

This isn’t to say that real estate is a bad investment.  It has its place in a diversified portfolio.  We’ll look at that in another blog post.

Oh, and if you want to see what the above chart would look like adjusted for inflation (CPI), here it is:
House Values Adjusteed For Inflation

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Thursday, November 4th, 2010 Real Estate Comments Off on How Much Bread is Your House Worth?

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I am not a registered financial advisor. I only offer opinions, and sometimes these opinions veer off at weird angles from conventional wisdom (That's probably why you are here). My advice is, "Don't take my advice." Read my sidelong glances at economic issues and form your own conclusions.

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