The paper describes 150 years of returns on equities, housing and then risk-less assets across sixteen countries.
Predictably, perhaps, it provides investors with tons of interesting facts and some really powerful insights. (You probably want to read the paper at some point.)
But one big insight? Many sophisticated, savvy individual investors grossly underestimate the attractiveness of investing in housing.
Let me, therefore, share three big lessons from Rate of Return on Everything paper.
After that, I’ll share four smaller ideas I’m taking away (and you may want to take away) from the study.
First Big Lesson from Rate of Return on Everything
The first big lesson from the Rate of Return of Everything paper? Housing delivers on average a better return than equities.
This better return isn’t free. Being a landlord requires work and stress. But over roughly the last 150 years and across 16 different countries, housing has generated slightly over a 7% arithmetic real rate of return while equities have generated slightly under a 7% arithmetic rate of return: 7.05% versus 6.98%.
That’s pretty close. In fact, we might almost call it a tie.
But—and this is the key part— at a country by country level the standard deviations of housing returns have run about half of those of equity: 9.98% versus 21.94%.
This difference in volatility means the actual compound average return on housing blows equities away. Equities, for example, return maybe 4% to 5% in real terms. While housing returns maybe 6% to 7% in real terms.
That’s big. Really big.
Second Big Lesson from Rate of Return on Everything
And a second lesson is almost as interesting as the first. Further, the second lesson is probably, in the end, more useful.
Housing investments show little correlation with equities. Maybe .2 or .3.
Just to add context, the Portfolio Visualizer website calculates that the Vanguard Real Estate Investment Trust (or REIT) index fund shows a .75 correlation with US stocks. Other traditional equity asset classes like international stocks show maybe a .8 to .9 correlation.
The low correlation of housing with stocks matters hugely if you’re trying to grind down your investment risks.
In fact, if the working paper’s calculations and conclusions are true, your and my first response may be to say we’ve been wrong about equities and we now need to get right with real estate.
Do the math, for example, and you pretty quickly calculate your housing investment should (in theory) be something over 90%.
Tip: You can download a spreadsheet that MIT’s Sloan School of Management uses to teach portfolio construction here. What the calculations show is this: If the equity and housing arithmetic average returns equal 6.98% and 7.05%, if the equity and housing standard deviations equal 21.94%and 9.98% and if the correlation coefficient equals to .3, we ought to invest 92% of our money in housing.
Don’t cash out of your equity funds just yet, however. Because I think we need to look at the third lesson from the paper, too.
Third Big Lesson from Rate of Return of Everthing
The third big lesson?
As you suspected, the theory works better than the practice.
Yes, at a macro level, housing performs way better than equities. But individuals encounter two problems acting on this insight.
First of all, we can’t practically invest 92% of our savings into housing. That $100 a paycheck or maybe a $1000 a month you or I save, for example? We don’t have a practical way to plop that amount into real estate systematically.
In comparison, you and I can easily invest $100 a paycheck or a $1000 a month into something like Vanguard’s Total US Stock Market index fund.
Anyway, that’s a first practical problem with going big into real estate.
And then a second impracticality: We can’t buy a country-level housing index.
Rather, your and my “housing investment” option is (usually) to buy a single property. Or maybe two. Probably in the same community where we live. And when that happens we don’t get that low risk the study authors calculate for national housing markets.
The Rate of Return on Everything working paper authors make this point in their paper, cautioning us,
… both individual housing returns and those of individual equities show a higher volatility than the aggregate indices. For example, we found that in the U.S., local (ZIP5) housing return volatility is about twice as large as aggregate volatility, which would about equalize risk-adjusted returns to equity and housing if investors owned one undiversified house.
In the end, then, most of us can’t go out and build a real estate portfolio that generates great returns with low risk.
We can on average get a good return. And we can dial down risk by building our portfolios with poorly correlated assets.
But we don’t get to earn a 7% real compound average return with a 10% annual standard deviation. Darn.
Nevertheless I wonder if we can’t still take away four actionable ideas from the study.
Idea #1: Residence First Investment
A first idea: Given the low correlation of equity markets and housing, something like a personal residence seems pretty attractive.
You and I want to be careful of course. Something affordable given our income and net worth. A place in a community where we can live and work for years. Or decades ideally.
But in the absence of bad luck, this investment in housing could easily be the best investment we make. It should deliver a good return if we’re careful. And it should play well with whatever savings we invest in equities such as through an IRA or 401(k).
Idea #2: Different Rules for Rich Entrepreneurs?
A second idea: Probably some people should go big with real estate. Let’s just admit that, recognize the data supports that decision.
For example, if you’re someone with the financial capacity to invest in a number of different properties scattered in a few different locations?
If you’re someone comfortable with the management workload of running what will quickly become a small business?
Heck, you can make a strong argument, I think, for re-orientating your portfolio toward residential real estate.
You should get the same average returns as equities generate. And you should also be able to push your risk down as you diversify across properties and geographically.
I will note, too, that real estate both under past tax law and current tax law provides investors with planning opportunities that can’t be matched by tax deferred retirement accounts and portfolio investments.
Idea #3: Opportunistic Investing?
I see a third actionable idea in the Rate of Return on Everything working paper.
Even if you and I can’t dial down the risk by investing in a number of properties and then spreading out the investments geographically, the low correlation with equities suggests we ought to consider bumping up our investment in housing.
Playing with that MIT spreadsheet I linked to earlier, for example, it looks to me as if just the low correlation alone makes it attractive to put maybe half of one’s savings into housing.
I’m thinking part of this investment is the home or condo or apartment you and I reside in.
But maybe somewhere along the way, if you or I get an obviously great opportunity, we pick up another property.
Maybe you keep the house you inherit from your mom. Or you buy the little building where you located your small business. Or you do buy that property you happen to know is very likely undervalued.
Idea #4: Small Business Investments Also Uncorrelated?
A fourth and final idea: Surely real estate isn’t the only alternative asset class you or I can invest in that shows good returns with low correlation to public equities.
Logically, an option like owning your own small business probably also dials down your portfolio risk and juices your portfolio returns.
Unfortunately, I can’t share robust data sources to back up this hunch. But let me point to a couple of resources that hint at this…
First, Rick Ferri talked around this issue in a post several years ago when discussing investing in really small public companies: The Truth about Microcap Index Funds. (If you read Ferri’s article, pay close attention to his discussions of correlations.)
Second, as you expect if your intuition matches mine, you do see in the databases of public company returns that correlations drop as firm size shrinks.
In fact, let me suggest this: If you’re comfortable using the Portfolio Visualizer Website, compare the returns, standard deviations and correlations of the mid-cap, small cap index and the micro-cap indexes to the total US stock market portfolio. As firm size shrinks, correlation drops.
I’ve got to get back to preparing taxes. The Subchapter S corporation and partnership returns are due over the next couple of weeks.
But do consider looking at the Rate of Return on Everything: 1870 to 2015 working paper. It’s a really profitable read.
And a related thought: If you’re a little foggy on how investments with the same rate of return but different standard deviations perform over time, take a peek at our blog post about building a Monte Carlo Simulation workbook in Excel. You might also be interested in our post about the myth of long-run stock market return chart . (That post visually explains the higher-than-typically-perceived risk of stocks.)
I’ll also mention that next week, we’ll talk about why a 100% stocks portfolio really, really doesn’t make sense.
A Final Postscript…
And a final postscript… A financial writer who I deeply respect wrote me a private note after the actual study data became available in the Spring of 2019.
In that note, this person made two important points about the data in the study. First, he expressed concerns about the accuracy of some of the return math because of various mistakes he had spotted (US data and some international data). Second, he pointed out that misaligned time frames for the inflation and return data scrambled the correlation measures.
As a result, he suggested you or I may want to double-check the return math for any country returns we rely on and then redo the correlation calculations using nominal data if we’re using such information. For the record, I haven’t double-checked his conclusions. But based on this individual’s long track record of correctness, common sense and precision, I know he’s right…