A recent poll of over 1,000 Americans conducted by Princeton Research Associates for Bankrate.com posed the question, “What is the best way to invest money you wouldn’t need for 10 years or more?” More than 1 in 4 Americans (28 percent) said real estate was the best investment for money they would not need for at least a decade. Unbelievably, cash came in second with 23 percent of investors. Only 17 percent said the stock market is their preferred place for long-term money, barely nosing out gold (15 percent). Bonds brought up the rear (4 percent) and “other” was selected by 6 percent of respondents. The results are frightening for the prospects of building long-term wealth and highlight the need for trained financial advisors.
Many people continue to believe the myth that residential real estate is the best long-term investment, and the evidence simply suggests otherwise. People fall prey to the stories of individuals realizing substantial gains by buying a home and selling it at a much higher price years down the road. The fact that in the United States a large percentage of an individual’s net worth is concentrated in home equity adds to the mistaken belief.
What many potential homeowners fail to realize are all of the attendant costs of homeownership beyond the mortgage payment – property taxes, insurance, upkeep, etc. Even before all of those extra costs, home ownership has not proven to be a very sound investment over time beyond the important emotional values such ownership provides for families. Noble laureate economist and Yale Professor Robert Shiller makes a compelling case that real estate, particularly residential homes, is a much inferior investment when compared to stocks. Shiller finds that on an inflation-adjusted basis, the average home price has increased only 0.6% annually over the past 100 years. Contrast that with the stock market. According to data compiled by Ibbotson Associates, from 1926 through 2016, the average return on a large stock index (the S&P 500) has been approximately 10% while inflation has average around 3%. The inflation adjusted return of the stock market over the past 90 years has been approximately 7%. In addition, stocks do not need a new furnace, a lawn mowed, or a new roof, and they do not require annual property tax payments.
Ironically, early in one’s working life, the biggest mistake people make is to take too little risk. Academic studies show that asset allocation (the mix of broad asset classes) is much more important to investor success than the specific assets purchased (that is, security selection), and the reason is compounding. The higher the annual return, the greater the power of compounding. Risk tolerance is about both the ability and willingness of someone to bear risk. Young people have the ability to bear risk because they have a long time horizon. But, often they don’t have the willingness to bear risk because of a fear of market downturns. In fact, a 2015 UBS study showed that millennials and the World War II generation have similar asset allocations — low allocations to equities and inordinately high allocations to cash. Both generations were shaped by cataclysmic financial events in their formative years. Many financial experts are also now beginning to counsel taking somewhat more investment risk extending into retirement than was previously thought prudent, especially in the face of increasing life spans and longer periods of retirement.
One of the biggest problems is how we describe the process of accumulating funds for retirement. Most of the time we emphasize the need to people to save for retirement. We need to change that narrative and encourage people to invest for – and during – retirement. Simply saving money and parking it in low-return asset classes is not going to enable people to reach their financial goal of funding a comfortable retirement or enable them to live well when they are retired. Advisors can play a pivotal role in educating clients on the need to prudently embrace risk assets, counsel clients during inevitable market downturns, and help them avoid the behavioral mistakes that investors repeatedly make when operating on their own.
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