Real estate has been a great diversifier over time. For investors not wanting to invest directly in properties, real estate investment trusts (REITs) offer an ideal vehicle to gain exposure to real estate through the public equity markets. Unfortunately, over the past several decades a new product has found its way on the market. The non-traded private REIT has exploded in the retail investor market, primarily sold by stock brokers and financial advisors. Here is typically the key points of the sales pitch:
- No price fluctuation
- 6% yield
- Diversification through ownership of commercial real estate properties
What's not to like? Having heard this sales pitch from the product vendors myself, at first blush they can be compelling. Unfortunately, that is not the entire story. Let me point out some of the downsides of these products:
- Huge upfront costs- typically only 85-90% of an investor's principal actually gets invested
- No liquidity
- Big commissions to the broker
- Historical underperformance
Recently, a study was released that seems to back up our thoughts that these products have no place in client portfolios. The study found that over $116 billion has been invested in these products over the last 25 years. Their study also found that these investors are at least $45 billion worse off than had they just invested in publicly traded REIT's over the same period. Returns of publicly traded REITs have been 11.3% per year while non-traded REITs have averaged 4% over that same period. Here are some of the return statistics:
You may be asking yourself, "if these products are so bad, why do they still exist?" The simple answer is money. These products pay huge commissions and fees to the brokers selling them and the providers of the funds themselves. If you have ever purchased one of these products, I would seriously question the advice you are getting from your advisor. The next time someone pitches one of these products to you, please reference this study and ask why this investment is appropriate.
If you are looking for a good journalist to read, you can't get any better than Jason Zweig of the Wall Street Journal. One of the complaints I have of journalists is that it is not in their best interest to tell the truth when it comes to personal finance. The reason- it's too boring. No one would ever continue reading their articles. Well, it looks like I may have gotten it wrong. Jason has a great quote about how he approaches the subjects he is going to write about:
"My job," Sweig says, "is to write the exact same thing 50-100 times a year in such a way that my editors and my readers will never think I'm repeating myself."
Brilliant. Good financial advice is boring. Boring doesn't sell newspapers. I love the fact that Zweig recognizes this but still attempts to tell the same story over and over again. But won't repeating the same concepts get old? Won't you lose readers? Zweig addresses this:
"There are three ways to get paid for your words:
- Lie to people that want to be lied to, and you'll get rich
- Tell the truth to those who want the truth, and you'll make a living
- Tell the truth to those who want to be lied to, and you'll go broke"
This concept not only applies to journalism. Financial advice follows these same rules. At Greenspring, there is a reason we don't sell certain products that seemingly offer high returns with low risk (variable annuities, private REITs, etc). While we might be able to make more money (ala #1 above) by selling something to people who want to believe there are free lunches, we want to be able to make a difference in our clients lives and feel good about the advice we are giving. Our success has not only come from telling people the hard truth, but finding people that are willing to accept the truth.
Most investors think about risk completely wrong. They focus on volatility but don't consider their holding period. As an investment industry we tend to look at a statistical metric called standard deviation. That measures how much volatility you can expect with a specific data set. The problem is that standard deviation is almost always quoted over a one-year period. But what investor has a holding period of one year? In reality, most people are investing for 10, 20 or 30 plus years. What should matter to them is not what volatility their portfolio could experience over one year, but over their entire investing holding period. Investors only realize losses after they sell. If they don't have to sell, no losses have actually been realized. As we have often said, there are really only two days that matter when you invest…the day you buy and the day you sell. Everything in between is just noise. As long as that noise doesn't scare you into selling, you can disregard the ups and downs of the market day-to-day, year-to-year.
How can I say this confidently? I know what the data says. First, let's look at risk and return statistics of the US Stock Market (CRSP 1-10 Index) from 1926 through September 2015:
- Average annual return: 12.07%
- Standard deviation: 21.20%
What that standard deviation statistic tells us is that over 1 year periods we can expect the following probabilities:
- 66% of the time we can expect returns to be between 33.27% and -9.13%.
- 95% of the time we can expect returns to be between 54.47% and -30.33%
- 99% of the time we can expect returns to be between 75.67% and -50.53%
No wonder people think stocks can be risky. Losses can be pretty common and losing a third of your wealth is just something you will probably need to accept at least once or twice in your investing career. But remember, these are stats over 1 year. How many of you are selling all your investments within the next year? Probably not many. More likely you need your money to last for decades. So when we look at risk, shouldn't we be looking over your time horizon, not over some arbitrary period like one year?
I re-ran the statistics but instead of 1 year returns, I looked at 20 year returns (annualized):
- Average annual return: 11.03%
- Standard deviation: 3.18%
These statistics tell us that over 20 year periods, we can expect the following probabilities:
- 66% of the time we can expect returns to be between 14.21% and 7.85%.
- 95% of the time we can expect returns to be between 17.39% and 4.67%
- 99% of the time we can expect returns to be between 20.57% and 1.49%
Looking at this data should shift your entire way of thinking about risk. Stocks really aren't that risky if you can hold them for 20+ years. In fact, when you look at them over longer time periods, they are even safer than bonds. For example, Long-Term Government bonds have a standard deviation of 3.51% over rolling 20 years (compared to 3.18% for stocks) and their average 20 year return has been 5.56%, about half that of stocks.
This is why most people should be holding a decent portion of their portfolio in stocks. As long as they can stomach the year-to-year volatility, their actual risk is quite low when you extend out their holding period.
*Data take from DFA Returns 2.0 Program
Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.