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Real Estate, Stocks and Bonds…

Real Estate, Stocks and Bonds... [1]

If one avoided all the news pertaining to the European situation, more specifically, how ineptly politicians are dealing with it, the second quarter of 2012 was a non-event. The price level of the US market was up about 5% while the Canadian market was down 3% year-to-date. Including dividends, the former is up 7% and the latter down 1.5%.

Unfortunately, politics will dominate news headlines until the US presidential election is over. We do not believe anything significant will occur before that. As for Europe, the disarray continues with Spain and Italy under pressure.

REAL ESTATE VERSUS STOCKS AND BONDS

Most believe that investing in real estate offers superior returns than stocks and bonds while having far less risk. If you were to listen to a casual conversation between friends and/or acquaintances, you would easily conclude that very few people have ever lost money on their house. In fact, most would say that it is their best investment. Furthermore, the same would apply to those investors who buy revenue generating properties. They would tell you that the rental income collected covers not only the expenses incurred in maintaining the building, but also part of the mortgage payments so that over the long term (5 to 10 years or longer), when they sell the property, they will end up with an interesting capital gain.

Although I would argue about how they calculate the cost of maintaining the dwelling, the uncertainty of the rental income and the impact of interest rate fluctuations, I would have to agree with the main principles of the investment:

  1. Long term in nature;
  2. Income generating assets;
  3. Leverage and
  4. Absence of daily market values.

I wish I could teach those same investors to look at their stock and bond portfolios in the same way:

  1. Long term in nature;
  2. Dividend and interest generating stocks and bonds;
  3. Here’s one difference… no leverage/margin (since as everybody should know by now, leverage is a double-edge sword) and
  4. Refrain from reading the newspapers and the internet for the value of your portfolio every day or week or even month.

As safe as you feel about your investment in real estate, you should feel safer if you own a well diversified portfolio of companies which in essence, track both the Canadian and American economies. The value of your real estate investment can only increase if the economy keeps expanding, can it not? An event such as the threat of a separate Quebec would affect the value of your real estate investment in this province a lot more than the Canadian or US economy, would it not?

Let us look at the main characteristics of the 2 investment assets (i.e. stocks and bonds versus real estate):

  1. One is a virtual asset (no maintenance) and the other is a physical one (maintenance in abundance… just ask someone you know who owns rental units);
  2. One has a readily available market value and the other does not (it needs to be evaluated by experts and takes time);
  3. One is very liquid and saleable and the other, not so liquid and requires time to unload.

As easy as it is to write these few lines underscoring the virtues of a stock and bond investment portfolio, it is very difficult to ask the average investor to look at the 2 investment choices (real estate versus a stock and bond portfolio) with the same perspective, mostly because of 3 reasons:

  1. Liquidity creates volatility which in turn makes investors panic. Unfortunately, volatility is plentiful in stock and bond markets while almost non-existent in real estate markets;
  2. The fact that real estate investors can see their assets or live in them (i.e. houses), gives them more comfort and
  3. Since real estate prices are not readily available on a daily basis, investors can make up the value of their investments in their mind. The perfect example of this phenomenon is reflected in the listing of some houses that were for sale for the last 3 years and still not sold. When asked, the seller would say something along the lines of: “I am not going to sell it below $1.2 million. The guy across the street sold his for $1.5 as is while I’ve renovated mine from top to bottom…” If you own IBM, and it trades at $200.00, it’s current market value is $200 if you want to sell it. How credible do you think a portfolio manager would be if the position was valued at $300 on your statement because that’s the price he believed it was worth?

A DIFFERENT WAY OF LOOKING AT YOUR PORTOFLIO WITH A LOT LESS STRESS…

We have been writing regularly about behavioral finance and understanding how it is psychologically very difficult to be rational about our investments. Rational behavior requires courage: “no guts, no glory.”

First, we need to understand the true nature of wealth, income and spending. Although most tend to measure wealth in terms of the dollar value of a portfolio, we believe that it is much better to measure wealth in terms of the spending that the portfolio can sustain over its life. The market value of your portfolio is only relevant when you want to liquidate. Otherwise, the recurring dividends and interest income generated are a much better reflection of your real wealth overtime. To put it another way, were the portfolio the goose with the golden egg, we would rather keep getting eggs from the goose rather than worrying about what the goose is currently selling for.

Benjamin Graham liked to distinguish between a temporary loss of value and a permanent one. The former is an opportunity and the latter a disaster. Truth be told, at some point during the 20th century, the stock markets of Argentina, Russia, Germany, Japan, China and Egypt each went to zero. Not that it could not happen in Canada or the US but if it was to happen, we would have much bigger things to worry about than stocks, bonds or real estate.

Meanwhile, temporary losses of value are frequent. At times, they can become so frightening that they become permanent -- for those who sell. However, through the lens of dividends received, these losses were much less severe. History shows us that, while the price level of the S&P500 could temporarily drop by 50% or more (the average drop of the 10 worst bear markets since 1900 was around 45%), the amount of dividends paid by the companies within the index barely fell (the average decrease in the amount of dividends paid (in dollars terms) is around 3%) with the exception of the great depression where dividends decreased by 25%. In terms of the real estate market, if rental incomes fell by 3% on average, do you think the value of your properties should go down by 50%?

Sadly, this is how schizophrenic the stock market is when you have so called “liquidity”. It does provide investors a way out but at a hefty price for those who do not have the courage and the nerve to stay rational. It is not so in real estate. During the mid 70s (with the election of The Parti Québécois), the early 80s (when interest rates reached 18%) and the early 90s (with the collapse of the Toronto housing bubble), we lived through recessions that had marked down your house price by 30 to 50%. Yet few people have actually lost money because they did not sell, did not want to sell or did not care since they were not planning to sell. For those who own income properties with reasonably sized mortgages, the same scenario applies. Most importantly, in real estate, it is easy not to want to know the selling price because it is nowhere to be found. However, this isn’t so for stocks: you have guys on the news, the internet and the radio. You even have special shows hosted by highly paid professionals dedicated to create excitement, greed, fear, euphoria and panic. It reminds me of the movie “Clockwork Orange” by Stanley Kubrick.

How can one be successful with financial markets, given all our psychological flaws? The answer is obvious: We need the courage to stick with profitable strategies through good and bad times. Here is how:

  1. As in real estate, look over the longer term;
  2. As in real estate, keep an eye on the income generated from our portfolio;
  3. Unlike real estate, do not use leverage because it will increase volatility, the exact ingredient that incites investors to panic and make bad decisions;
  4. Use market volatility to rebalance and/or increase the portfolio’s income.

Fortunately, Mr. Market, being bipolar and subject to wide mood swings, is also exceedingly generous: he will pay you a much higher dividend rate by lowering the stock price he is willing to take – if you have the courage to take it from him. Thus, a strategy with a methodical, disciplined and slightly contrarian tilt can provide us the courage to stay the course in adversity and even to take on more discomfort when it is most profitable -- and most frightening -- to do so.

The Claret Team