Real Estate, Stocks, the Tortoise and Hare

By Shawn Lucas

In the well-known children's tale of the tortoise and the hare, the tortoise outpaces the hare in a stunning victory. If real estate is the tortoise, recent performance clearly reflects the moral of this story-and the stock market, that rascally rabbit, is the source of investor nightmares.

Hailing the victory of the tortoise, many diehard real estate investors ignore the stock market-but at what cost? It's true that the seemingly flimsy nature of the stock market makes real estate investing look rock solid. For the past 40 years, home sales have outpaced inflation by a steady one or two percentage points per year. But before you place your bets on tortoise power, don't underestimate the rabbit!

U.S. real estate prices have increased more than 56 percent from 1999 to the end of 2004. During the same period, the S&P 500 index dropped nearly 6 percent. However, if your only point of reference is the last few of years of lackluster stock market performance, you're missing the bigger picture.

Go back further, and you'll see that the S&P 500 actually outpaced the real estate market nearly 4 to 1. From 1980 through 2004, home sale prices increased 247 percent. During the same time period, the S&P 500 shot up more than 1,000 percent.

Volatility

Historical data shows that both the real estate and stock markets suffer blips and dips, but over time both tend to smooth out in a positive-trending return on investment curve. The difference is when either market suffers a decline. On the way down, real estate prices tend to show more resilience than stock prices, probably because real estate investors are more reluctant to sell in downturns. While the largest decreases in real estate are on the order of 5 percent in any given year, it's not uncommon to see a 20 percent decline in stocks. But when real estate drops, the housing market tends to stagnate or lag for years; the stock market tends to rebound quicker.

So where is the best place for your money: real estate or stock market? The answer is not one or the other; many investors consider both. The difference between the stock and real estate market is the degree of volatility, which is the oscillation between buyer's and seller's markets and the resulting driving of prices up or down. Until recently, real estate investors experienced less volatility than the stock investors. But the recent boom in real estate has increased the volatility of the housing market and returns have increased. Over the long term, however, real estate's volatility mildly outpaced inflation figures, lending to the notion of security in the real estate (volatility and security work in opposite directions). By contrast, volatility in the stock market has yielded a 1,000 percent increase in the last 25 years.

A diversified approach

Smart investors never put all their eggs in one basket, and we definitely do not recommend putting all your money in the stock market. A strategy commonly used by successful investors is to include both stocks and real estate in their investment portfolio.

How much of your investment portfolio should you allocate to real estate or stocks? The answer depends your risk tolerance and personal comfort level. Consider that if the next 25 years perform similarly to the last, stocks will outperform real estate four to one. This means that if you allocate one-fourth of your real estate portfolio to stock, you can effectively boost your return on investment by almost 200 percent (See Chart 1). Conversely, if the stock market drops 25 percent in the same time period, you would miss out on only 17.5 percent of your over all real estate returns (See Chart 2.) In the worst case, your portfolio will be up 206 percent; in the best case, you'll see gains of 437 percent. By applying sound investment strategies, you can make diversification work as a strong wealth-building tool.

Chart 1

Chart 2