Today I’m talking about “the best investment.”
Specifically, I’m answering three questions:
- How do we define “best investment?”
- What metrics might we lean on to evaluate different investments?
- What separates a good investment from a bad one?
I’m also sharing a personal story that caused me to change my approach when giving opinions about different asset classes.
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- Stay Wealthy Episodes Mentioned:
- Risk & Performance Metrics (1/2000 – 06/2023)
- Sharpe Ratio
- Investing in Real Estate Point/Counterpoint
- Government Bonds vs Corporate Bonds
The Best Investment
Taylor Schulte: I strongly believe that residential real estate is a bad investment.
I think that most people underestimate the cost of buying, owning, and maintaining a home and fail to take those sizeable costs into consideration when calculating their total return. Factor in your time, the headaches, and the stress homeownership can cause, and it’s hard for me to make a good case for this asset class.
My wife is well aware of my feelings about real estate and, while on a long drive recently, she decided to dig a little deeper and asked to learn more about why I thought real estate was such a bad investment.
She has some good friends who primarily invest in real estate and they often share with her what a great investment it has been. In fact, they tell her that they’re actively trying to save more money to buy more real estate.
“What am I missing?”, she asked. Why do you feel it’s such a bad investment while others I know suggest it’s the best investment they’ve ever made?
Welcome to the Stay Wealthy podcast, I’m your host, Taylor Schulte, and today I’m talking about evaluating our investments, what separates a good investment from a bad one, and why some very well-known performance metrics and formulas are problematic.
To grab the links and resources mentioned in today’s episode, just head over to youstaywealthy.com/191.
Warren Buffett didn’t achieve billionaire status until the age of 56. In fact, 99% of his current net worth was earned after his 50th birthday.
Successful investing requires time and patience. It also requires conviction and commitment.
Buffet is one of the most successful investors in history because he adopted an investment philosophy that he believed in and stayed the course. He doesn’t chase investment fads or jump from one hot stock to another in the hopes he’ll time the trade perfectly.
His approach is to buy stocks at a good price and hold them for long periods of time. For example, he started buying shares of Coca Cola in 1988. 35 years later, Berkshire Hathaway's $25bil stake in the beverage company now accounts for 9% of all outstanding shares.
When my wife brought up the topic of real estate investing in the car and asked me why it was such a bad investment, to my surprise, I didn’t go into defense mode. I didn’t try to defend my thesis with data and numbers and attempt to convince her that I was right and those who disagreed with me were wrong.
Instead, I found myself focusing on the words “bad investment.” Calling real estate a bad investment seemed to strike a different chord when she said it out loud and it led me to share with her one of my favorite investing quotes that I’ve repeated a lot here on the podcast lately. And that is, “the best investment - or the best investment philosophy - is the one you can stick with. ”
Instead of talking about all of the reasons I thought real estate was a bad investment, I started by sharing with her why it might actually be a good investment. I shared that one of the hidden benefits of investing in real estate is that it’s illiquid.
I.e., You can’t turn on your computer and sell your house tomorrow with a few mouse clicks like you can with stocks and bonds. For that reason, it incentivizes longer term holding periods, and that’s a huge positive my opinion. Long-term investors, on average, have more success than short-term.
I also shared that the definition of “best investment” is, of course, subjective. It’s also personal and unique to the investor.
For example, contrary to what you might be thinking right now, my wife and I own a home. By most measures, a nice home in a nice neighborhood that represents a fairly large % of our net worth.
I didn’t agree to sink our life savings into this asset because I think it provides us with the best return on our hard-earned money, but because it provides our family with stability, access to the best public schools in the county…our parents live 10-20 min away, and we don’t have to live with the risk of our home being sold by our landlord, forcing us to relocate with three young kids at an inopportune time.
For me.. and my family…and our unique goals and values, those somewhat hidden or intangible benefits actually make my home a great investment. They provide a return on life far greater than an S&P 500 index fund that might technically have higher future expected returns.
Contrary to what we might tell ourselves, our friends, and/or spouses, I’d argue that most investors are not focused on achieving the highest rate of return possible when evaluating and choosing investments.
My wife’s real estate investor friends, for example, likely have other reasons for investing in that asset class, even if those reasons aren’t documented in their financial plan or investment policy statement.
For one, it might be what they know and what they’re comfortable with. It’s not comforting to invest in something you don’t understand. So, investing in real estate – something physical they can see, touch, and understand – may give them peace of mind and help them sleep better at night. What sort of price tag – or premium – might you place on feeling comfortable with how and where your money is invested?
It’s also possible they might enjoy owning properties across the country because they don’t want to live in one house 365 days per year. They might place a lot of value on being able to move around to different cities, and stay in a property they own when they do.
Or…they might have an expertise in maximizing the return on real estate. You can absolutely earn competitive returns in real estate, but like most things in life, it takes a lot of work. Your average homeowner doesn’t have the skill or the time to find, buy, improve, manage, and maintain a complex and expensive asset like real estate.
You can’t just buy a house, hire a property manager, sit back, and expect to clip 10% each year. But if it’s your passion and you’ve developed the skills and you have the time to dedicate, it’s very possible to achieve above average returns.
Too often, I think we get stuck thinking about and talking about “the best investments” too literally. Myself included.
But, what makes something a good investment? What separates a good investment from a great investment?
Some might say that the best investment is the one that has had the highest historical returns. But, we of course, have to remind ourselves that past performance doesn’t guarantee future results. Historical performance can be one helpful marker to use when evaluating an investment, but there are other metrics that should be included as well.
For example, the performance of an investment doesn’t take risk into consideration. An investment may have produced the highest historical return, but how much risk was required in order to earn those return?
With that in mind, we might then find ourselves defining the best investment by the one that has had the best – or is expected to have – the best risk-adjusted returns.
While risk-adjusted returns are another important factor to take into consideration – and an improvement from just looking at performance – this approach also has flaws. For example, a popular financial metric for measuring the relative risk-adjusted return of an investment is the Sharpe ratio.
The Sharpe ratio can be calculated on any given investment or portfolio and, to keep things extra simple here, the higher the Sharpe ratio, the better. A higher Sharpe ratio indicates that an investment has had better relative risk-adjusted performance.
But again, while the Sharpe ratio can be helpful – and can be one metric to lean on in your analysis – it also has flaws that may not necessarily lead us to identifying the best investment.
For example, let’s look at three different funds and their Sharpe ratios from January 1st 2000 - June 30th 2023.
Fund #1 (total bond) had a Sharpe ratio of 0.59
Fund #2 (small value) had a Sharpe ratio of 0.48.
And fund #3 (S&P) had a Sharpe ratio of 0.40
Based on what I just shared about using the Sharpe ratio to identify the investment with the best risk-adjusted return, we would go ahead and say that Fund #1 is the best because it has the highest Sharpe ratio.
But now let’s reveal the funds and look at some of the other performance metrics during this same time period.
#1 - vanguard total bond, 4% std, 4% annualized return
#2 - dimensional small cap value, 22% std, 10% annualized
#3 - Ishares S&P 500, 15.5% std, 6.75% annualized
It’s pretty clear that measuring risk-adjsuted returns, on their own, is problematic and flawed, and not always useful to your average investor. The Vanguard total bond fund has the highest Sharpe ratio because it has the lowest risk as measured by the standard deviation. But lower risk, as illustrated by the historical performance, means lower returns.
Which might be considered good for investors targeting capital preservation and bad for investors looking for long-term growth.
In addition to getting caught thinking about the “best investment” too literally and getting hyper-focused on a handful of metrics, we also to avoid evaluating investments in isolation.
If you type in “the best investment” into Google and you’ll find hundreds of articles listing investments that the author suggests are the best. Everything from t-bills and high dividend stocks to crypto and real estate.
Instead of evaluating investments in isolation, I’d suggest that it’s more prudent (and more beneficial) for investors to measure how investments behave and perform together in a diversified portfolio.
For example, if you compare corporate bonds to government bonds in isolation, you might conclude that corporate bonds are the better investment. But if you compare each as part of a diversified portfolio, you’ll likely come to a different conclusion. I’ve referenced it in the past, but I’ll link to a research paper or two on this topic in the show notes.
The other benefit to evaluating investments as part of a diversified portfolio is that the diversification benefits typically improve the behavior gap. I.e., a properly diversified portfolio has proven to be easier for investors to hold onto for long periods of time which, in turn, improves the investors’ returns.
Buy a single investment that’s too risky and you might find out you don’t have the stomach to hold on through all the ups and downs to reap the high long-term returns. Alternatively, you might opt for a low-risk investment and begin to feel like you’re missing out on market returns, causing you to bail and try something riskier.
The primary reason I’m an advocate for including small cap stocks, value stocks, international stocks, and AAA-rated government bonds as part of a globally diversified portfolio for those who are nearing retirement or in it is NOT because I think it’s a superior approach to portfolio construction that will produce the best return… but because of the diversification benefits it provides.
The recent episodes I’ve published on International Stocks and The Lost Decade are great examples. In retirement, when we are relying on our investments to produce a paycheck, we don’t want everything in our portfolio moving in the same direction. Most people can’t afford to go through a 10-year time period of negative returns like the U.S. stock market produced from 2000 to 2009. Most people would also struggle to stay committed to their investment plan as well.
While it’s not confirmed, there is an often referenced story suggesting that Fidelity once examined all of the investment accounts on their platform to identify which accounts had the best performance and why. The conclusion was that the best performing accounts were owned by those who forgot they had them.
The best investment doesn’t exist.
The best investment – or the best investment portfolio – is the one you can stick with…even if sticking with it means you forgot it existed.
The best investment is also the one that aligns with you, your goals, your values, and your needs.
So, through this conversation with my wife and my time preparing this episode, I’ve realized that I sometimes get caught painting with too broad of a brush when giving my opinion about different asset classes.
Real estate is not a bad investment.
Setting my primary home aside, I don’t believe that real state is a good investment for me, my goals, and my investment philosophy, but it could very well be a great investment for someone else.
So how you do you evaluate your portfolio? What do you think separates a good investment from a bad one? What investments do you own that, on paper, might lead someone to conclude it’s a “bad investment” but you have other, personal reasons for maintaining it? I’d love to hear from you. Shoot me an email at firstname.lastname@example.org and share your thoughts.
Once again, to grab the links and resources mentioned in today's episode, just head over to youstaywealthy.com/191.
Thank you, as always, for listening and I will see you back here next week.
Episode Disclaimer: This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.