What is the Best Investment You've Ever Made?
It’s fascinating to hear the answers to this question when posed to those who have been investing for at least a few decades.
Without skipping a beat, most people say that their home has been their best investment. When I press them as to why, they’ll typically respond, “because I bought it at “X” and it is now worth “Y”. The gap between X and Y can easily reach six figures. Then I’ll pull out my trusty calculator and ask more questions for clarification.
“How much did you pay for your house and when did you buy it?”
“What do you think it is worth today?”
Ignoring any major renovations or repairs they have made over the years, I compute their average annual rate of return on what they perceive to be their “best investment!” Despite geographical differences and time frame, the results tend to be strikingly familiar. The return on their “best investment” turns out to be 3-5% even while ignoring any major renovations or repairs (which would lower the return if factored in).
3 – 5% per year? This doesn’t sound to me like it should be your lifetime’s ‘best investment’.
Most people know that a diversified investment portfolio has yielded a much higher return, historically speaking. To me, this begs the question: why do people think that their home is such a great investment? I have a few ideas.
Our homes tend to be a big ticket item in comparison to other financial assets.
For example, it is not uncommon for a 30-year old to purchase a $200,000 home whereas it is fairly uncommon for a 30-year old to have already saved $200,000 in an investment account. So mentally your home is a big number to you and any perceived dollar growth in it makes people believe it has actually achieved a larger percentage rate of growth than it really has. They never actually do the math to compute a growth rate, they simply base it on the dollar growth and since their home is a bigger number, the dollar growth psychologically feels bigger.
Case in point, let’s assume this 30-year old buys a $200,000 home and a year later its valued at $220,000 on Zillow. During the same time period, this 30-year old’s $50,000 investment account increased from $50,000 to $55,000. Because your home value is larger, the $20,000 increase in value feels bigger and much better than the $5,000 increase in your investment account when, in reality, the percentage increase in both were exactly the same.
A home is a different kind of investment.
It’s not purely financial. If your kids are dialed in to their school district and you love your neighbors, neighborhood, location, etc., a downturn in the home markets may simply be a non-event for you. Barring a job loss or job relocation that you may necessity you to move, you most likely won’t get too worked up about a downturn in the real estate market.
When real estate values dip, we mentally fall back on the idea that it isn’t a financial investment. We tell ourselves, “that’s ok, I’m not going anywhere anyway” or “this is my home, not an investment”. Then over time, values stabilize, and we begin to forget about those depressing times for our home value. With investment accounts, we don’t get any tangible benefits today if they’re earmarked for the future, so the dips feel more painful and more scary.
We can’t see an exact value of our home every day.
Sure, you might peek at what a neighbor’s home sold for or occasionally check out Zillow, but you don’t really know what your home is worth until you have a sales contract in hand. We tend to buy a home and pay less attention to the value until we want to sell. With our investments, however, we can see the value 24 hours a day, 7 days week, 365 days per year.
There are a few dangers in knowing the exact value of your portfolio every day. We might ‘anchor’ to the high-water values. For example, in the midst of the great recession, most people could tell you their portfolio’s exact value at its peak. It’s less likely that we have this mental history with our home values. When it takes a while to reach and surpass those high-water marks with our investment portfolios, doubt starts to creep in that they may not be all that great.
If we didn’t see the values of our portfolios as often, my suspicion is we’d be pleasantly surprised at the growth. You would probably be ecstatic about your investment portfolio’s growth if you only looked at their values every 5 years.
Think of it this way – if a family member you see every day loses 50 pounds over the course of a year, it can go unnoticed. If, however, you go a year without seeing someone and they’ve lost 50 pounds, you can’t believe the difference. Investment account growth is similar to watching someone lose a pound a week over a year. You hardly notice it.
The psychology of why most people believe they’ve earned a better rate of return on their home than from their diversified investment accounts is fascinating. Again, most of us will own a home for a consistent 10, 20 or 30-year time period and I would suspect if you hold any real estate for this long of a time period you will make money on it. However, I would also argue that if you would have held a diversified investment portfolio for the same length of time that you would have achieved much higher returns. Unfortunately, our behavioral biases will never see it that way.
Investing in the markets is just like investing in your home, it involves patience. If we can be patient and keep the long view on our homes, then we must be able to do the same with our investments. If you do, you will reap the rewards, but it will also mean that you will need to deal with a little volatility along the way. In the end, as great as an investment as your home is, I would argue that your investment account has probably been a better investment as long as you didn’t allow your emotions to get in the way.
So I challenge you, if you have owned your home for greater than 10 years, do the math. Determine what annual rate of return you have averaged and then let us know your results.
