Imagine strutting into the gym and surveying the scene, from squat rack to towing ergometer to Pilates reformer, with absolutely no idea what equipment to use, how to use it, or what it does for your body - then throwing yourself into a workout without asking for instruction, aid, or advice. As absurd - and dangerous - as that would be, it’s an apt analogy for the way many Americans choose to invest their money. In its annual poll, Gallup lists five investments and asks respondents which they think is best for the long term. According to the most recent survey, real estate was the top pick, at 30 percent, followed by the gold and stocks/mutual funds, tied at 24 percent each. Savings accounts and certificates of deposits (CDs) were the favorite of 14 percent of investors, while six percent chose bonds.
Not surprisingly, the results of the poll were summed up by one financial website in this headline: Americans Are Still Idiots When it Comes to Investing.
Because, with a few caveats, here’s how those options actually compare: If you had invested $10 in gold in 1926, it would be worth about $615 today. If you had put $10 into the average home that year, that would be worth $241 in 2014. Ten dollars invested in the stock market, however, even with the crash of 1929, would be worth $55,000. In other words, it’s not even close. Stocks crush the other options. (Savings accounts and CDs pay squat, so it’s not a fair fight there.) Are the returns for the next 90 years going to be exactly the same? Of course not. But the stock market will run laps around those other options. Why? Because when you invest in companies that are making profits and plowing that money back into their business, and you reinvest the dividends they pay you, your long-term returns will be higher than if you bought static assets such as a house or a shiny metal.
Well, what does anyone expect? They don’t teach this stuff in school, and you’d have to spend a long time with The Wall Street Journal, Forbes, or Fortune before you’d gain a decent understanding of the respective benefits and pitfalls of each option. To make the best decisions about investing, some smart advice would come in pretty damn handy. Here it is.
Play the stock market - but throw the ball deep
While real estate can have a great effect on your finances, stocks are a great investment that, if you’re not disciplined, can make an otherwise rational guy act like a cokehead at a frat party. With real estate, people tend to worry about what it will be worth in 10 or 20 years, which is a smart way to invest. Ask your parents’ friends what they paid for their house and they’ll all remember. Ask them where the Dow was trading that year and they’ll have no idea. But they probably know what stocks did yesterday. And that’s the problem.
Because people can check prices of stocks every day (or every minute), they tend to overreact to meaningless short-term movements. They’re euphoric when their stocks go up, and devastated when they fall. The resulting greed or panic leads to bad decisions — like buying in good times and selling in bad. The result: As countless studies have shown, the returns investors actually earn in the market are much lower than the market’s performance.
And this, of course, is why respondents in the Gallup poll think real estate is a better investment than stocks: They’re comparing the inflation-juiced profits of decades of home ownership with the scars of bad stock-investing decisions in recent bear markets. Simply stated, real estate makes them smart and stocks make them stupid.
The only way to win in stock investing is to find the strength to ignore the short-term moves. Treat your retirement savings like a mortgage: Make monthly payments regardless of market conditions. Don’t try to pick stocks, and don’t pay the fees required to invest in mutual funds that try to beat the market. Instead, buy a cheap passive fund such as the Vanguard Total World Stock Index Fund Investor Shares (VTWSX), which owns shares of more than 6,000 companies around the world, with about half of those in the United States.
I have no idea how the fund will perform over the next year or two, but as those companies churn out profits and dividends, they’ll become more valuable. Over the decades, it will far outstrip the appreciation you’ll see in the average house.
Believe in CDs (Just Don't Expect Miracles)
For money you’ll need in the next few years, certificates of deposit are a good bet. CDs, which pay more than a savings account in return for your agreement to let the bank keep your cash for periods ranging from a few months to several years, are guaranteed by Uncle Sam, and some five-year CDs return around 2%. Look for one with a low early-withdrawal penalty. Even if you cash out before it matures, you’ll do better than you would have with, say, a one-year CD that paid next to nothing.
But don’t think of a CD as an investment — it’s a garage for your money that might come close to keeping up with inflation.
Be Realistic About Real Estate
“But,” you say, “my parents paid just $28,000 for their house in 1971 — now it’s worth 10 times that!” True. And guess what: A gallon of gas cost 36 cents in 1971. Today a gallon of gas sells for about, well, 10 times that. When you go back far enough, as people tend to do with houses, inflation plays a big role in price appreciation. By comparison, compounded gains in the stock market, including reinvested dividends, would increase your 1971 investment by a factor of 80. Sure, inflation takes its cut out of those earnings too — but they’re big enough to withstand the pain.
Yale economics professor Robert Shiller, whose data I used to calculate the real estate returns above, estimated that during the 100 years leading up to 1990 — before the housing boom — home prices rose only an average of 0.2 percent a year after inflation. According to Standard & Poor’s, stocks have returned an annualized 10.2 percent.
I’m not suggesting it’s a bad idea to buy a house or an apartment. In fact, it’s a pretty good idea. For starters, it provides shelter, which you’d have to pay for anyway. More important, home ownership tends to encourage better financial decisions. People who “can’t save a dime” somehow find a way to send $1,500 monthly mortgage payments to the bank for 30 straight years. USC professor Richard Green thinks of it as getting to live in your piggy bank.
Would they have made more money if they’d plowed that $1,500 a month into the stock market? Of course.
Consider Gold, But Just a Nugget
Gold has no earnings, it pays no dividend, and you can’t live in it. In the end, it’s only worth what someone will pay you for it.
Gold is a fear trade: When people are scared, they buy gold. Some fear that stocks or bonds will crash. Others think the dollar and other paper currencies will plummet in worth, leaving gold as the only good store of value. Others think President Obama is conspiring with fellow world leaders and the National Oceanic and Atmospheric Administration to enslave us all.
Because the first two could happen (and if you think the third could, you’re not going to want our advice anyway), there’s nothing wrong with owning a little of the yellow metal — but make it no more than 5 percent of your portfolio. One easy way is to buy an exchange-traded fund such as the SPDR Gold Shares (GLD).
Do a Little Bonding
If you’re already in your 20s or early 30s, the standard advice would be to have around 30 percent of your retirement account invested in bonds. Right now, yields are unusually low, however, so future returns don’t look great. The best approach is to diversify as much as possible and understand that if the stock market tanks, bonds should act as a shock absorber, as they did in 2008.
And someday, when your kids ask you how much you paid for the house, go ahead and impress them. Then blow them away by describing your stock market gains.