Questionable Investment Ideas

Here’s a questionable investment idea. If you invest with me, I can guarantee you a 2% low-beta return. I know fees are on everyone’s mind, with an extra .1% in fees in a mutual fund enough to make you want to reconsider the whole investment. In my idea, if you want to get your money out in the 5th year, I can normalize my fees to be something like a “2-and-66″ – I get 2 percent baseline, and an additional 66% of your profits. Technically I get 6% baseline if you want your money out, though maybe higher, regardless of performance.

What am I going to call this new fund? It’s called “The Housing Market.”

I appreciate Adam Ozimek’s defense, and his rebuttal to Felix’s critique but this gives it away:

“Say you live in a neighborhood that you believe is going to clean up, crime will go down, housing stock will improve, and rent is going to go from $500 a month now to $1,000 in three years and then grow at 8% a year perpetually.”

The market return during boom times is 8-10%. The best evidence I’ve seen for long-term housing appreciation from Shiller is something like 2% from 1940-2000. Does Adam really think housing is a better return than the S&P 500 on an arbitrarily long time period?

The problem in the speculation story is that land is illiquid, has incredibly high transaction fees and is a “lumpy” good, which means it is terrible for speculative purposes. Hedge funds and speculators should be people picking up nickles in front a steamroller. This model of speculation is like using a steamroller to catch a rabbit with a nickle on its collar.

Felix notes: “DanHess and Matt Turner make the point that buying a house is a great way of forcing people to save over the long term.” There are no free lunches of course, and the reason it is a great way of forcing people to save over the long term is that it is incredibly expensive and difficult to get any money out of it. A 6% fee for selling is a baseline, and with 2% appreciation you need to be in the house five years to not lose money (and even then it nets to a “2-66″ hedge fund fee). If your house has appreciated, there’s no way to sell off half your investment in it, in the same way if you speculate with stocks you can sell off half your stocks in order to hedge. Shorting REIT stocks and praying aside, there’s little in the way of actually hedging the housing itself.

For a marginal dollar of investment, it’s hard for me to think of a good reason to put it into housing rather than a diversified mix of risk-free bonds and a market aggregate portfolio. If you want housing for a hedge because of its (supposed, is this true?) low beta, why not just go T-bills or commodities? If you like leveraging up in the low beta zone is Adam suggesting people take out negative amortization loans? Interest-only loans? That would be the way to juice up the leverage the most. However it’s important to remember how incredibly volatile local housing markets can be.

These are my quick thoughts. This is an incredibly important issue for consumer financial literacy, so I like that there is a critical discussion ongoing.

UPDATE: Check out Richard Serlin’s comment below.

This entry was posted in Uncategorized. Bookmark the permalink.

28 Responses to Questionable Investment Ideas

  1. Beer Numbers says:

    I agree with your broad point, but I’m not sure I understand this:

    Felix notes: “DanHess and Matt Turner make the point that buying a house is a great way of forcing people to save over the long term.” There are no free lunches of course, and the reason it is a great way of forcing people to save over the long term is that it is incredibly expensive and difficult to get any money out of it.

    I think it’s more of a behavioral story – people are saving without necessarily realizing that they’re doing it.

    I wrote some more here:

    http://beernumbers.blogspot.com/2009/12/housing-as-investment.html

  2. Mike says:

    Beer,

    I meant to bring up the 401(k) analogy, where it is a binding mechanism to force people to save – excellent post! I do like that story, and you are right that a nudging behavioral approach is really what they are alluding too. The obvious problem is that if you need to sell your house and move in 4 years, if you weren’t catching a boom period it’s likely that, post-fees, you’ll be negative on it, and it’ll force you to stay longer unless you can eat the loss. So it’s a binding mechanism for super-rational people as well.

  3. dsquared says:

    how does it change if a) you’re allowed non-recouse finance to invest in this fund and b) if, having decided not to invest in the fund, you have to pay the fees anyway (ie, you’ve got to include the homeowner’s imputed rent in the total return!)

  4. richardhserlin says:

    Clearly, a home you live in, on average over the long run, is a much worse investment than a well diversified stock portfolio.

    Jeremy Siegel has some great data on asset returns in his book, “Stocks for the Long Run”, 4th edition. This includes American stock data all the way back to the birth of the New York Stock Exchange in 1802. The geometric average for 1802 to 2006 is 6.8% above the inflation rate, and it’s about that for subperiods 1802-1870, 1871-1925, and 1926-2006 (page 13).

    For real estate, meanwhile, in Robert Shillers data set (at: http://www.econ.yale.edu/~shiller/data.htm), he has real home prices going from a starting base in 1890 of 100 to 130 in December of 2009. That’s a compound real return of 0.2%, and when you subtract out maintenance and modernization costs and homeowners insurance (not to mention utilities and furniture; taxes are about a wash, with property taxes about equaling, or exceeding, any mortgage interest deduction), then the real return on a home you live in is negative. By the way, what if that 100 were invested in stocks at 6.8% real? It would grow to $235,184, compared to $130 for real estate, not counting the expenses of maintenance, modernization, etc., and negative counting them.

    A home you live in is more an expense than an investment. Of course, it’s an expense that may be well worth paying for the enjoyment (as long as it doesn’t put your fixed “Must-Have” expenses over 50% of your after tax pay, see Harvard’s Elizabeth Warren’s book “All Your Worth”).

    Now, a home you don’t live in, one that you get rent from, that can be a good investment, but only if you have the learning and skill to do this kind of investing well, and it’s a lot more time consuming than just putting your money in the Wilshire 5000.

  5. Beer Numbers says:

    dsquared,
    You raise valid points, but if you’re going to add in your two factors favoring the housing investment, you also need to add in things like:
    c) opportunity cost of down payment
    d) property taxes, insurance, maintenance
    e) transactions costs (amortized over appropriate horizons, of course)
    many of which are ignored in these discussions.

    Evaluating the desirability of purchasing a home is obviously a complicated task, but my subjective sense is that the arguments I’ve seen online for housing as an investment are more often than not superficial and unpersuasive.

  6. Mike says:

    Thanks Richard. I was hoping you’d sneak into this debate, and I’m glad I wasn’t too far off. Now blog it so we can all link to it :)

  7. Adam Ozimek says:

    Mike,

    The specific numbers I used were simply for a particular hypothetical, I wasn’t making any statement about returns in general. Also, everything I’ve written on this was in specific reference to owner-occupied housing investment. I haven’t given any thought to housing as an investment for hedge funds or other institutional investors. .

    Regarding the issue of why should anyone ever invest in housing instead of t-bills or commodities, housing markets can be small and local enough that individuals may actually have better knowlege about future prices than the other relevent buyers and sellers, enough so to potentially “beat the market”. That is not true in commodities and securities markets, where hedge funds and investment banks are.

  8. richardhserlin says:

    I should note that while your home is more of an expense than an investment; the larger more expensive a home you buy, all other things equal, the less wealth you will accumulate, it still may be less of an expense than rent, especially rent on a similarly expensive home, and if you are not moving for at least five years so you don’t get killed on buying and selling expenses. Note, though, that renting a small cheap apartment will make you wealthier than buying a large expensive home if you put the savings on downpayment, mortgage, insurance, etc. in the Wilshire 5000 and get the average returns. Note also that if you bought a $400,000 home to live in, you could have bought a $200,000 home to live in, and a $200,000 home to rent out, and you would still get $400,000 in home price appreciation, but you would in addition get to collect rent on a $200,000 home.

    Paying off your mortgage as fast as possible is also a good investment for most people, because it’s very safe. Even losing the mortgage interest deduction, it’s still a very good return for such a safe investment (as long as you really think you will be staying in that house securely, as opposed to having to perhaps walk away from the mortgage anyway)

    Bankrate.com lists the current 30 year fixed mortgage rate (for very good credit) at 4.99% (not counting points and other fees). A 30 year U.S. Governemnt bond is at 4.48%.

    Suppose you pay off your mortgage faster, then you save 4.48% interest, but you lose the deduction. If your taxes are 30%, then you end up with an interest savings of .70 x 4.99% = 3.49%.

    With a government bond you get 4.48% interest, but you pay taxes on that interest. Again assuming a 30% tax rate, you end up with .70 x 4.48% = 3.14, less than the 3.49% you get from paying off your mortgage, and the difference gets bigger as your credit, and therefore mortgage interest rate, get worse.

    A paid for home adds a lot of security by keeping your fixed, “Must-Have” expenses a lot lower, and this is especially true in states that allow you to protect a lot, or all, of your home equity in bankruptcy, not all states by any stretch.

  9. Adam Ozimek says:

    Also, note that I’m not referring anywhere to all investors, or even many. I’m arguing that “housing to live in is never an investment” and “you should never buy a house to live in and as an investment” is false. I actually think I’m making a fairly modest argument, and I think a lot of the pushback is a visceral reaction against Irresponsible speculation in owner occupied hosting, which we’ve all just witnessed an abundance of.

  10. Mike says:

    Adam, I think Serlin nails it; “beating the market” is really an illusion in many cases once you take in fees and transaction costs (my point) and alternatives and extra costs (Serlin’s points). And, especially ESPECIALLY important for regular consumers, investments aren’t about “beating the market”, they are about growing a pile a wealth for future consumption. Encouraging regular investors to try and ‘beat the market’ is a bad strategy imho.

    I agree with you in the general sense that housing can be considered an investment like baseball cards are. It’s just not a very good one.

  11. Adam Ozimek says:

    Yes, I’m sure many people are ignoring costs. That’s beside the point though, unless your arguing that those costs make it impossible to profit from owning a home.

    I don’t mean to be dismissive about interesting points you and others are making about the general issue of owner occupied housing invesmnts, but people keep telling me these things that have no merit on the specific argument I’m making as if they did.

    It’s possible for an individual to have better information about future prices and rents than the seller pf the home and the few buyers who are looking at it. Housing markets are local, and thin, and heterogeneous. “don’t try to beat the market” is a fine rule of thumb, or even investing principal when you’re talking about bond markets. Bu it is not sound advice for guy who has found a house down the street from where he’s renting that’s obviously undervalued. He decides that’s a nice place, and this neighborhood is rising in value. I can live there for five years, sell it, then move to the suburbs. If you told him, “Dont try to beat the market Bobby!” you’d be giving him bad and advice.

  12. Beer Numbers says:

    Adam,
    I don’t think your point regarding information asymmetry is a sound one, for two reasons:
    1. Everyone is a buyer and seller roughly the same number of times, so if you think buyers are especially likely to have better information, then when it’s time to sell, you get hosed by the same argument.

    2. It seems especially unlikely that, if there is information asymmetry, that the buyer of a home has better information than the seller (i.e., the one who actually lives in the house).

  13. Adam Ozimek says:

    Beer Numbers,

    To your point 1, I don’t think buyers are especially more likely to have better information. Some people, buyers and sellers, have better information than others. That’s about an uncontroversial of a statement as you can get.

    To your point 2, you’re talking about a world where buyers systematically have better information than sellers; that is not what I am saying. If it were you would be correct, that is unlikely.

  14. Matt Turner says:

    I don’t recall making the point about forced saving recently, but it’s probably true enough. My view of the housing market, and why I think a lot of this anti-housing as an investment is silly, is that it’s a consumption good you will always need to consume. You’re not going to suddenly decide in 2027 that you might do without housing for a while. On that basis alone then it’s quite sensible to store it up for when you have no income, ie in retirement. It’s an almost perfect hedge of a large chunk of your consumption needs.

  15. Matt Turner says:

    To add to the above the debate has to be conducted on the basis that buying a house to live in is a completely different concept than buying houses as an investment per se. One can be a good idea and the other not (which in fact is my view).

  16. Beer Numbers says:

    Matt Turner,
    Yes, it’s important to save for future housing consumption while we’re still earning money, but that doesn’t mean the vehicle for saving should be a house. Similarly, I don’t think anyone would argue that we should save for our future food needs by filling our basements with cans of soup.

    More here:

    http://beernumbers.blogspot.com/2009/12/housing-as-investment-2.html

  17. Jack Bates says:

    I believe in order to make valid statements in regard to validity of homeownership as an investment one critical factor that must be considered is the fact that our Government subsidizes homeownership by provided a tax deduction for the interest expenses. This single factor dramatically alters the net outcome of home ownership for most people who are wage earners.

    Given that a person must live somewhere there are certain expenses that must be considered ‘fixed’ when evaluating the scenario on a case by case basis. Most of this discussions seams to remove that simple fact from the equation.

    Is homeownership always the best investment choice – absolutely not. Particularly for those who have short term housing needs or little tax burden. But for many (if not most) working americans with jobs, and long term ties to a location and community it still appears to me that home ownership is a solid, if conservative, investment.

  18. Turbulence says:

    This single factor dramatically alters the net outcome of home ownership for most people who are wage earners.

    Does it really? I mean, most taxpayers don’t even itemize deductions so they can’t take advantage of this tax break, and many others that might itemize do better with the standard deduction anyway.

    Moreover, shouldn’t we expect that at least some of the mortgage tax deduction will be passed on to renters in the form of lower rents? Granted, tax incidence questions are hard, but if you eliminated the mortgage interest deduction, wouldn’t you expect rents to increase at least a little?

  19. dsquared says:

    Jeremy Siegel has some great data on asset returns in his book, “Stocks for the Long Run”, 4th edition. This includes American stock data all the way back to the birth of the New York Stock Exchange in 1802. The geometric average for 1802 to 2006 is 6.8% above the inflation rate

    WAHHHHHH WHATTHEEFFINGFWORD, DUUDE!

    You’re comparing *total return* on stocks with *price appreciation* on houses!

    If stocks had seen 6.8% annual price inflation since 1802, then the Dow would currently be at a level of approximately 900,000. Nearly all this return is from reinvested dividends. Houses pay dividends too, in the form or rent or imputed rent. This calculation is totally, totally screwed, and it leads to absurd conclusions like the comparison with baseball cards. If this is financial literacy then there is no hope for any of us.

    • Yeah, but there are two points:

      1) Many people actually do think that the home appreciation alone is competitive with, or better than, the total return on a diversified stock portfolio, so I want to make clear that that’s been shown not to be the case.

      2) You save your rent expense whether you buy a moderately expensive home, or an extremely expensive home, so it’s important to make clear that buying a bigger more expensive home is not good investment-wise, all you get is more home price appreciation, which is not very good on average, no additional rent savings. So contray to the belief of many, stretching to buy the most expensive home you can get is not a good way to invest. You would on average be a lot wealthier if you bought a less expensive home to live in and invested the savings in the Wilshire 5000.

  20. Jonathan says:

    Great post – but one question. You comment that there is little reason to put into housing, which is logical as an investor. As a resident, though, you have to consider the alternatives. The alternative to not owning real estate is renting. Compared to renting, you are at least accumulating assets rather than giving your cash away to someone else.

    Thats the best reason to go into housing that I can come up with.

  21. Bruce says:

    You ignore two things in the investment return of your own house. Your biggest portion of the return is the rent you don’t have to pay. Its the equivalent of a tax-free return in the equivalent rent on the property. Add in the tax free appreciation and tax deductible interest.

    Even if you pay all cash the tax shelter is huge. If you rent, and invest cash in securities, you pay taxes on the return from the investment that you use to pay the rent.

  22. gabe says:

    Bruce and Dsquared are right, one needs to consider the implicit rental stream of income gained by not renting.

    Most people don’t consider that this is about the only return you can expect, while most people circa 2004 expected 8-10% returns now and forever.

    Instead of having a majority of their wealth in housing, people should hold a more diversified portfolio of assets.

    The most annoying thing to me is the idea that if you don’t own a house by age thirty you’re some kind of hippie/drifter/failure, etc.

    After all, who rents? It’s just “throwing your money away”. (Unlike renting skis, movies,cars, etc. which is not throwing away your money, right?)

  23. Housing is a long term consumer durable and (with an amortizing mortgage) a default savings mechanism. In short, the reasons to buy a house are (1) you want stable tenure in a particular neighborhood; (2) you like the house; (3) you can afford it.

    Some people love their cars. Some people love their wine. Some people love their art. And some people love their houses.

  24. Let me echo dsquared and Bruce. Before we bought our house (in 2006), I made up a spreadsheet which calculated the net present value of buying (assuming no appreciation above historical CPI) and of continuing to rent, including under the income stream from the latter what we could’ve made by putting the down-payment in an index fund at the long-term growth rate. Buying had a higher NPV assuming we held on to the house for at least five years, largely because we were _already_ making rental payments comparable to our mortgage payment.

  25. Blissex says:

    «Buying had a higher NPV assuming we held on to the house for at least five years, largely because we were _already_ making rental payments comparable to our mortgage payment.»

    Sure, but that all depends on the interest rates. If they are low enough that mortgage payments plus other housing costs are lower than renting, that means that money is cheap relative to real assets, and real assets are a good inflation hedge. If government policy is to create asset bubbles, not joining is is indeed expensive.

    «The most annoying thing to me is the idea that if you don’t own a house by age thirty you’re some kind of hippie/drifter/failure, etc.»

    Or you are a German or live in another country where government policy is different from driving down real wages and up real asset prices via credit bubbles and loose monetary policies.

  26. Myles SG says:

    I am curious if Shiller’s study makes the distinction between urban housing in areas like Manhattan, or wealthy suburbs like Greenwich, and say, a house in Detroit or Minneapolis.

    I would imagine that the price evolution of those markets to be quite different. I mean, I would imagine it would be a safe bet on a London townhouse, or a largish Surrey Edwardian, or a house in eastern Long Island, for the next century, whereas it would be a much less advisable bet on say, Inland Empire in California or some random Texas suburb.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s