Why stocks grow, real estate doesn’t & bonds are less risky?
When you first set out investing, you get told lots of little analogies. “Buy stocks for growth”, “diversify”, “your investment in bonds should equal your age”, etc. This is all great advice, but is it true and why does it work? Why do stocks grow and real estate doesn’t?
Why do stocks grow faster than other asset classes? It’s the magic of compounding. Basically, a business is able to compound up its growth, while real estate and fixed income doesn’t.
Why stocks grow?
The first thing we should clarify is that we are talking about value, not price. Yes, there is a difference between the two.
Value is the amount something is worth, price is the amount you pay for it.
Now if you believe efficient market hypothesis, the price of an investment will be reflective of all known information and hence be a good reflection of its price. I would say that in some cases, in very deep and liquid markets, this may be true.
When you purchase stock you are buying a piece of a business. A business that has people, products, brand names and a balance sheet. It is more than just a collection of assets. Each period, your business has sales which brings in cash and pays out expenses to generate those sales. The remainder at the end is the profit. Two things can happen to this profit, its either paid to the stock holders as a dividend or its retained in the business to help it grow. They grow by hiring more staff, creating new products or expanding into new markets.
Some very fast growing businesses, think tech companies, reinvest everything they earn back into the growth of their business. Older, more mature companies, lack growth opportunities that require massive investment and tend to pay out most of their profits as dividends to the owners.
And Real Estate doesn’t?
Lets say you have an investment property. Each year the tenants pay you rent. Some of that rent goes towards paying for maintenance of the property, insurance and taxes. If you’re leveraged, then it will also go towards paying interest on your mortgage. The rest goes straight into your pocket.
Now you could reinvest the rental income you received. Perhaps the property can be expanded by adding another bedroom or a second story. Maybe putting in a pool or tennis court will increase the amount of rent you can charge. But its not “organic” growth. Where as a company can increase its size and profitability by increasing sales, cutting costs etc. To make a property “bigger” you need to actually “invest” in it.
The example below demonstrates this simplistically. Both the business and the property start with $1,000 in equity. Each period they earn a 10% return on their investment, but the business only pays out 60% of what it earns while the property must pay out 100%. The remaining bit that is retained by the company is reinvested. Perhaps more stock is bought or another sales person hired.
At the end of 5 years, the “value” of the business is $1,217, whereas the value of the property is still $1,000. Now remember, the value isn’t necessarily the same as price. But broadly speaking the business will have a higher value than the property.
|10% return Year 1||$100||$100|
|Paid to investor||60%||100%|
|10% return Year 2||$104||$100|
|Paid to Investors||60%||100%|
|After 5 years|
When compounding works in reverse
When a business is growing, compounding is a wonderful thing. One of the great investment discoveries of all time. However, when it goes in reverse, it goes a lot faster as well. This is why stocks are “more risky” than real estate. Their value can go up fast and down fast.
In our example above, the worst that the investment property can do is produce zero income (we assumed there are no costs). However, it is more than possible that the company would lose money. Perhaps they lose a major client or their expense get too high. Either way, their return could be negative.
Real Estate and infrastructure – the inflation hedge
But real estate and infrastructure investments are often great inflation hedges. What doe this mean? Well, it means as prices rise (inflation), they are able to increase the amount they charge in rent. Often this is baked into the contract. Commercial leases often allow for CPI increases with their tenants, while large infrastructure (think toll roads) having set price increases each quarter. These increases can be a minimum of a certain percentage or inflation, whichever is higher (so they can’t lose!).
Unfortunately, bonds neither grow nor does it have an inflation hedge component in it, unless its a TIP. So you might ask why invest in bonds and fixed income at all? Well, because they have less risk. That is, in the event of bankruptcy its the bond holders who get paid out first, with the stock holders only getting a return at the end if there is anything left. Some special types of bonds like hybrid securities have qualities of both fixed income and equity.
Also, their price (which isn’t the value remember), is a lot more stable. It’s highly unlikely a bond will double or halve in value over a year, but a stock could easily do that.
Bond are less risky than equities for two reasons.
- the bonds have a limited life. This makes them less risky because you know when you will get your capital back.
- unless there is a credit event, you get the face value of your investment back at the end of the life of the bond.
- your return is pre-determined. The coupon is set out in the term sheet.
- if the worst happens and your investment goes bad, the equity holders are written off first. This is especially the case for corporate bonds.
With stocks on the other hand, there is no final date. They are perpetual. The only way to get your capital back is either to wind up the company or to sell the investment to someone else. Your return in the form of dividends depends on the profitability of the company. Sometimes companies have great growth periods and dividends go up every year. In other times companies make losses, maybe because of an incorrect strategy or changing market conditions. Either way, if a company makes a loss, then the dividend is cut, usually to zero.
Does this make stocks the better investment?
Yes and no. Like so many things in life, it depends on your circumstances. If you have longer time frames over which you are investing (think years to decades) then investing in stocks makes much more sense. But adding real estate to your portfolio adds a more stable income stream. You asset allocation is an important determinant of the expected returns you will generate. Overall, you should always remember that stocks will grow and real estate doesn’t, while bonds are the least risky.