With Investing, the Grass is Rarely Greener on the Other Side

Quick note: I’ll be participating in a Huffington Post Live segment tonight at 9pm EST on the topic “Can You Afford a Baby”. If you’d like to check out my first on-camera experience and have a little fun with how awkward I look, you’ll be able to see it here: HuffPost Live: Can You Afford a Baby?

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I talk a lot on here about investing. To me, it’s such an important topic because it’s one of the best ways to ensure your family’s financial security and because there are so many misconceptions about how it should be done. There’s decades of evidence showing that the best investment strategies are actually incredibly simple, but still there are always people searching for something better. That search for the mythical magic bullet, the one that gets you great returns with minimal risk, is not only a waste of time but can be incredibly harmful to your ability to build wealth.

And that is exactly why I thought Erin’s piece over at the new site Economag (check it out!) earlier this week was so important. She wrote A Love Letter to Millennials, From The Stock Market, which brought up some really important and foundational points on investing successfully. I’d like to explore some of them in a little more depth today.

Overview

You should definitely read the entire article yourself, but as a quick overview Erin came across a piece from the Wall Street Journal highlighting the fact that many young people are avoiding the stock market and instead putting their money into real estate. And not just any real estate, but multi-million dollar houses and apartments. The overall sentiment seems to be that they feel like the stock market is too risky and that real estate is a much safer investment. Erin’s plea is for these young people to recognize that nothing has delivered better long-term returns than the stock market, and that participating in those returns is a great way for people to build long-term wealth.

The strange effects of recency bias

As human beings, we have a tendency to overweight the significance of recent events. Something that happened just a couple of weeks ago feels much more likely to happen again than something that happened a few years ago, even if decades of history tells us otherwise.  This effect is called the recency bias, and whether you understand its significance or not can have a profound effect on your investment success.

In deeming the stock market too risky, the young people featured in this article are exhibiting a classic case of recency bias. They started their professional lives, and likely their first real chance to invest, in the midst of the financial crisis when the stock market was tanking in what felt like a never-ending death spiral. That experience clearly spooked them, and now they’re staying away. That’s unfortunate for many reasons, chief among which is the fact that they’re completely bypassing the single biggest driver of their long-term investment returns. You can certainly avoid the stock market if you like, but it’s going to make it a lot harder to build wealth than if you instead took a history lesson, learned that there are always ups and downs, and decided to live with them for the long-term rewards.

There’s risk in every investment

On the flip side, these same people are proclaiming real estate to be a safe investment when we JUST WENT THROUGH A GODDAMN HOUSING CRISIS!!!! Seriously, I will never understand people. I have nothing against real estate as an investment and in fact am enticed by the idea of owning a rental property myself at some point in the future. But to think it’s a “safe” investment is just a little delusional. First off, if you’re simply talking about owning your own home, that is not an investment. You might save money over renting if you live there long enough, but you’re still consuming shelter, not investing your money. And there are many risks involved with rental property as well that cannot be ignored. You’re likely taking on more debt, you may have destructive tenants or no tenants at all for periods of time, there are ongoing maintenance, tax and insurance costs, you are subject to the rising or falling prospects of your neighborhood, and so on.

The point is that no matter where you’re putting your money, there is always risk. Even with “safe” investments such as savings accounts and CDs, there is the risk that the true value of your money will decline because of inflation. We tend to overweight the risks that we have personally experienced, feeling like the next investment will be safer simply because he haven’t personally felt the negative effects it can have. Rather than jumping from thing to thing based on personal experience, it’s much more prudent to understand the long-term risk and return characteristics of each type of investment and make a plan that fits your long-term needs and willingness to take on those risks.

Risk of being undiversified

When investing, diversification is your best friend. Diversification has many different forms, but at its core it’s the practice of spreading your risk across many different investments so that no single investment has the ability to lose all of your money. So you not only invest in many stocks instead of just a few, but you also spread your money across stocks, bonds, real estate, etc. It’s the single way you can decrease your investment risk without sacrificing your expected returns.

One of my big problems with real estate as an investment, especially for young people, is that it can leave you extremely undiversified. Even if you only purchase a $50,000 home, how big a percent of your net worth is that? 50%? 90%? Chances are it’s pretty high, which means you’ve just hinged most of your wealth-growing potential on the prospects of a single piece of real estate. That’s a big risk that you should think long and hard before taking.

Conclusions

There are two big lessons we need to learn from Erin’s story:

  1. There is risk in every investment. Successful investors understand the different types of risk involved in each and create a diversified investment plan that meets their individual needs.
  2. Don’t let recent or personal experience play too big a role in your decision-making process. There’s a lot of randomness to short-term behavior and basing your long-term decisions off that randomness can be incredibly detrimental. Instead, take some time to understand the long-term behavior of each type of investment and base your decisions off that.

Photo courtesy of Eliza

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36 comments… add one

  • DC @ Young Adult Money August 9, 2013

    There are definitely risks with rental property! We have a basement rental and there is always the risk we won’t have a tenant (thankfully have one booked for the next year) and maintaining it takes some money. Overall though I love the fact that we have some additional revenue coming from it.

    • Matt @ momanddadmoney August 9, 2013

      It’s definitely a great way to get some extra income if you do it well. But as you say, there’s also risk involved. The problem with any investment really comes when people start ignoring the risk.

  • Rita P August 9, 2013

    Agree there is risk in every investment and one must carefully diversify the investment keeping long term goals in mind and not carried with the short term returns or experience

  • Holly Johnson August 9, 2013

    I am very suspicious of the stock market in general, but I’ve forced myself to invest anyway for the reasons you’ve mentioned. I also invest in real estate as well….it’s risky too. Hopefully at least a few of the things I’ve invested in will turn out well =)

    • Matt @ momanddadmoney August 9, 2013

      You guys definitely seem like you’ve done a good job diversifying. I like the way you’ve factored rental properties into your retirement plans a lot. Done well, it can be a great investment.

  • The thing is, while I while it took me a while to figure out why a building that wears out over time should appreciate, I’ve NEVER understood why we are supposed to expect the stock market to go up.

    • Matt @ momanddadmoney August 9, 2013

      A building should only appreciate as much as its replacement cost appreciates, which on the whole is basically just the rate of inflation. As for the stock market, it’s just made up of businesses, which are made up of humans trying to provide value for other humans. As long as you think that value can continue to be provided, you should expect returns from the stock market.

  • Laurie @thefrugalfarmer August 9, 2013

    GREAT article here, Matt!!! You’re so right on about the recency bias. Long term, the market always has done well and has a what, nearly 100-year track record? This is a simple case of people eating what they’re fed and not doing their own research.

    • Matt @ momanddadmoney August 9, 2013

      Thanks Laurie. We’re at 100+ years at this point. I like that phrase “eating what they’re fed”. Never heard that before.

  • Andrew August 9, 2013

    Good article. I still remember when I was just out of college and many people my age were spooked by the stock market because of the internet bubble. I thought it was a good time to invest and I think the stock market…while it has had its ups and downs, has been a good investment.

    • Matt @ momanddadmoney August 9, 2013

      You definitely have to be able to put up with the ups and downs, which isn’t always easy. But most people that are able to do that are rewarded well.

  • BrokeMillennial August 9, 2013

    Thanks for the shout out! This is a great post! And THANK YOU for addressing that real estate isn’t as safe as everyone seems to think.

    • Matt @ momanddadmoney August 9, 2013

      Thanks Erin! You did a great job starting this topic. Real estate definitely isn’t safe. It can be a great investment, but it’s far from a sure thing.

  • Grayson @ Debt Roundup August 9, 2013

    Nice article Matt. Personal or recent events always tend to skew people’s rationale. That is why there are successful and unsuccessful people in this world. Some continue moving on through the bad times and others change their strategy.

    • Matt @ momanddadmoney August 9, 2013

      I like that generalization a lot. Success definitely requires the ability to chart a plan and keep executing even when times are rough. Certainly there’s some amount of re-evaluation needed, but it should be based on all available information, not just recent or personal information.

  • SeanMcNulty August 9, 2013

    Great article Matt, there is no 100% safe investment. Even the main competition to investing is doing nothing with your money and adhering to the ‘Cash Is King’ philosophy. Even then you are losing out to inflation. You hit the nail on the head with ‘diversification is your best friend’, just like choosing a best friend you should choose a diversified investment strategy that best fits you; i.e. that plays to your risk tolerance.

    • Matt @ momanddadmoney August 9, 2013

      Couldn’t agree more. Each person’s ideal investment strategy will be different, even if we all base it off of the same core principles. Finding what works for you is very important.

  • Shannon Ryan August 9, 2013

    Great post, Matt. All investments have risk and if anyone tells you differently – run. It is a bit odd that they would consider real estate to be so safe since the housing crisis was not that long ago. Unfortunately, too many of us don’t take the time to learn about investing ourselves and just follow what others say, assuming they know what they are talking about.

    • Matt @ momanddadmoney August 9, 2013

      Yeah I didn’t understand why the housing crisis didn’t seem pertinent to them either. Especially since it happened at the same time as the stock market crash.

  • Done by Forty August 9, 2013

    I wonder why recency bias isn’t also pushing Millenials to invest in the stock market. Both stocks and real estate tanked at exactly the same time, and have been on a recent recovery ever since. And while this depends a lot on where you live, but in general I think the stock market has been doing better than real estate in the past five years.

    As usual, there are a lot of great lessons in your post. Risk and reward do go hand in hand, diversification (especially across asset classes) matters more than just about anything else, and stocks are the highest performing asset class. You cannot reach your wealth potential if you ignore stocks.

    On the flip side though, your comment about how much of our net worth is tied up in real estate is pretty damning. We have nearly 50% of our assets in our home, as we decided to pay it off. And we’re about to buy rental property! I feel okay about it as we’re still investing a good chunk of our income in the market, but at this point in the journey we’re pretty heavy in property.

    • Matt @ momanddadmoney August 9, 2013

      ‘I wonder why recency bias isn’t also pushing Millenials to invest in the stock market. Both stocks and real estate tanked at exactly the same time, and have been on a recent recovery ever since.”

      That baffles me too. And I don’t think they really addressed it in the original article. But it seems very strange.

      As for your personal situation, I don’t think what you’re doing is necessarily a bad thing, I just think that people should fully understand what they’re getting into beforehand. As long as you guys have a full understanding of the risks you’re taking and the returns you might expect either way and make an informed decision, I trust you’ll be fine. It might not work out as hoped, but you’ll be prepared for it. But hopefully it turns out great and your rental property brings in income for years to come.

  • E.M. August 9, 2013

    I completely agree that there’s risk in every investment. I plan on diversifying in the future to have money in both areas. Maybe the hype with all the low-interest rates on mortgages and house flipping shows are sparking younger people to go for it. You don’t exactly see fun shows on investing in the stock market. After watching so many of these shows, and seeing others be successful at making a profit off a house flip, others are eager to try their hand at it. People may also perceive real estate to be less boring and easier to understand at first glance (I don’t think that’s true) as opposed to the stock market.

    • Matt @ momanddadmoney August 12, 2013

      Your idea about the influence of house-flipping shows is definitely interesting. Anything on TV usually looks much easier and less involved than it actually is. And house-flipping is even more risky than purchasing rental property, as you’re so dependent on that short-term selling price.

  • Where are these millenials afraid of the stock market? More common seem to be some of my friends that think they are investing geniuses for having great returns since 2009 and are talking about doing all sorts of crazy moves with their money since they have “skillz”. Duh. As long as you didn’t pull money out, you probably had amazing returns since 2009. So I guess that’s recency bias of a different shade.

    BTW – thanks for the mention on our duplex post!

    • Matt @ momanddadmoney August 12, 2013

      Yep, I’ve definitely seen a lot of that too. It’s pretty easy to be a successful stock-picker when all of the stocks are shooting upwards.

  • Pauline @ MakeMoneyYourWay August 10, 2013

    wow huffington post that’s huge! well done Matt. I wish my internet was good enough to watch those things.

  • addvodka August 11, 2013

    Congrats on Huffington Post – that’s a huge deal! Also, you’re absolutely right; no investment is without risk.

  • Martin @ hellosuckers.net August 13, 2013

    Matt, this is so true. I noticed the same trend that people think that in real estate they can get a better deal. And it is not necessarily true (as we actually experienced recently). When comparing real estate to stocks, it needs a lot more attention than stocks dealing with tenants, repairs, claims and who knows what else. I think stocks can provide a lot better and passive return.

    • Matt @ momanddadmoney August 13, 2013

      I think real estate can provide great returns when done properly, I just think people get into trouble when they think they’re getting something for nothing. Or when they view their primary residence as their biggest investment. That’s a problem as well. Though I do agree that an investment portfolio can be put together that provides good returns with little effort.

      • Martin @ hellosuckers.net August 13, 2013

        And I am not in disagreement to that. If done properly. But, and that is my opinion, would require more work and effort that stocks. But that’s because my experience with real estate is negative since in the past I managed a property of a friend of mine, so never more for me :)

        • Matt @ momanddadmoney August 13, 2013

          I’ve never managed property, but the amount of work is definitely one thing that makes me hesitant. I don’t think it’s quite as easy as many people make it out to be. At least not in all cases.

      • Martin @ hellosuckers.net August 13, 2013

        I agree, if you select for example dividend paying blue chips, the effort is a lot lower than would be needed for real estate.

        • Matt @ momanddadmoney August 13, 2013

          My preferred method is index funds. I think that staying on top of your dividend stocks requires more work and I’m skeptical of the reward. But in any case, I think we’re in agreement that traditional investing can be a great way to secure long-term returns with reasonably minimal efforts, other than educating yourself up-front as to what you’re doing.

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