Funds and Real estate - Investing path part 2

Why investing with funds is problematic? how good is real estate and what are the pitfalls?

December 11, 2020

Snir's investing desk is a newsletter focused on intelligent, value investing for the individual investor. The subjects are evergreen and deals with the essence of investing, mental models, and concepts.

Recap for savings and index funds

In part 1, we started exploring the alternatives we have for investing our money as individual, working investors.

We first looked at savings, which doesn't work since inflation has a devastating negative compounding effect.

Then, we looked at index funds. Historically returns an average of 7% per year. But you'd get these 7% only if you ride the market through bad and good times.

Many investors are scared out during crashes and lured in during bubbles. This pattern repeats - for recent examples, look at the 2000s dot com bubble and 2008 market crash.

The second significant risk is that index funds are currently in a bubble state. Michael Burry, who predicted the 2008 crash and made millions from shorting the market back then, claims that index funds are like subprime CDOs.

Let's assume that it'll work out great for you, and you'll make an average 7% return per year for the next few decades. If you don't go to extreme savings and a strict lifestyle, it will usually mean late retirement (age 65~) with an average lifestyle.

Use the investor calculator to check out your specific conditions.

investor calculator tool

Saving 1k$ a month with a cost of living of 60k$ will allow retiring only at 67

Funds - Hedge funds, mutual funds, and more

You would probably call a professional for anything hard that requires some education. You wouldn't teach yourself how home electrical engineering works. You'd call an electrician.

The same line of thought leads people to give away their money to professional money managers.

The thing is, where we have plenty of evidence that any electrician can do a far better job than any layman, this isn't true for funds at large.

Understanding why funds underperform can warrant a series of posts by itself. I already wrote one that touches one angle of it in long term horizon is our investing edge.

Leaving the reasons for another time, let's focus on the statistics. Given you have access to common funds like mutual funds, what can you expect?

The distinction of talking about "common funds" is essential. Private funds and hedge funds have either strict regulation or just a common closed garden (depends on the country), which prevents any individual investor from giving them money. If you are an accredited investor with millions of dollars in the bank and have access to Li Lu - this is a different story.

Back to the common funds' performance numbers - deciding on the method to check this thoroughly is hard. A short search in google will give you plenty of research papers from top universities trying to quantify this in different methods, usually spending the first 6-10 pages on defining the terms.

The gist is this: most funds underperform the market. By some definitions, it's more than 75% of the funds.

One semi-anecdotal point I like to refer to is Buffett's bet from 2008 that ended in 2016, where the opponent picked 6 funds of funds against the S&P 500. He lost, all of them underperformed the S&P 500.

funds vs S&P 500

The results of the bet - funds vs the S&P 500

So, no reason to go with any hedge fund, right? Passive investing in the S&P 500 consistently beats the fund managers.

Not necessarily. You still have to weigh the potential risks of index funds investing. For example, if the S&P 500 is indeed in a bubble state, funds might outperform it substantially in the coming decades.

Real estate

When I talk about real estate here, I refer to buying a house and rent it. Investing in REITs or companies that manage real estate assets fall under the "active investing" section.

With this definition, it's evident that real estate is a different creature within these posts series context. It operates under different rules, and yet it is closest to the "active investing" category.

Buying real estate requires research. You need to know the market, learn how to value an asset, search for good assets - then examine them yourself, etc. Much like researching a company for investment.

But then you have all the differences:

You can leverage

You can leverage in stocks too, but it's dangerous for various reasons and very expensive. When buying a house, the entire financial system is set up to allow you to take a big loan for very low interest rates.

The leverage can make your effective returns on the investment much, much better.

How much better? It depends. It depends on various variables that it's hard to talk about it in "general". Every case is different.

And it might just be that real estate is a fantastic path for your specific case. This is why I built the real estate investing calculator, so you can get a visual sense of what it means for you.

Real estate calculator

The real estate calculator

It's hard to change your mind

When you buy a house, you go through all the regulatory processes, probably get a mortgage, go through weeks of ping-pongs with lawyers and accountants to finally own the home.

Say you discover a month later you made a mistake on your analysis of the asset. Selling it will be challenging and time-consuming. Not to mentions the pure loss you'll have from the cost of taxes and services of lawyers, realtors, and more.

It's a cash flow provider asset

Earning a 7-9% yield from an asset is common in real estate while having more than a 5% yield on a dividend stock usually means something is wrong with the company.

The returns are lower

An average real estate asset appreciated at an average ~3% per year.

That's low. It becomes more lucrative as you have higher leverage. But higher leverage is also higher risk.

Don't forget; something might happen to lower your specific house or your particular neighborhood value. And in that case, the leverage is a powerful tool to the negative.

No diversification

A young person that can afford one real estate asset due to their high cost can end up with his entire wealth on a single asset with no diversification at all.

High leverage with no diversification is risky. If the single asset fails, for whatever reason, you have no hedge, and you are in deep debt.

Real estate summary

Real estate investment is a powerful tool to build wealth using leverage in a very stable market.

It has its risks, mainly revolving around the high leverage and lack of diversification. It's also very time consuming to find a good deal on the market. But when you do - it's a powerful tool.