The asset classes of real estate and stocks both offer cash flow and passive income, but their annual returns are likely to be very different. If you want a higher long-term rate of return, one is likely to serve you better.
Here's a closer look at stock investing and real estate investing, along with their pros and cons, to help you determine which fits your needs and situation better.
What is stock investing?
Investing in the stock market can be immensely rewarding -- delivering great wealth over time, often with some fun and excitement thrown in as well. You do need to take the time to learn the basics so you can avoid costly blunders.
There are different ways invest in stocks, too -- some are quick and easy, and others are more time-consuming and require significant knowledge and skills. Here's a review of three key options you have for investing in equities: individual stocks, mutual funds, and index funds.
Think of companies that interest you, and companies you patronize. Familiar American names include Apple, Nike, Starbucks, Netflix, Ford Motor, Walt Disney, McDonald's, and Costco. In fact, as of the end of 2017, there were about 3,600 companies listed on U.S. stock exchanges.
You will need a brokerage account to place orders to buy and sell various stocks, ideally with one of the best brokerages. Once you set up an account with one and send in some money to fund it, you'll be good to go. Don't make any moves, though, until you're confident that you know what you're doing.
There's a lot to learn about stock investing, so let's start with an introduction of the key categories of stocks to know about:
Large-cap, mid-cap, small-cap, and micro-cap: These qualifiers describe a company's market capitalization, or market value. They're determined by multiplying the number of outstanding shares by the company's current stock price. So a company with 50 million shares and a stock price of $20 would have a market cap of $1 billion. Here's a rough guide for categorizing companies by market cap:
Market Cap Size
$10 billion and greater
$2 billion to $10 billion
$300 million to $2 billion
$50 million to $300 million
Blue chip stocks vs. speculative stocks: The term "blue chip" refers to established, solid companies that are well-known and are relatively reliable performers. At the other end of the spectrum are speculative stocks, which might not be profitable yet and attract investors with their potential rather than their performance track record. Speculative stocks include penny stocks, which are equities that trade for less than $5 per share.
Dividend-paying vs. non-dividend-paying: Another way to distinguish stocks is according to whether they pay shareholders a dividend. Whenever a company posts a profit, there are numerous things it can do with that money, including paying off debt, hiring more workers, buying more advertising, or issuing a dividend to shareholders. Dividend-paying companies are typically relatively stable, with predictable cash flows. Younger, faster-growing companies usually don't pay dividends because they are reinvesting profits for further growth.
Growth stocks vs. value stocks: These relate to two prominent investing styles -- growth investing and value investing. Growth investors favor buying stock in fast-growing companies and they can be willing to pay a lot for them. They'll often ignore a seemingly steep valuation -- when a stock is being priced at a level that seems higher than its current estimated intrinsic value -- expecting the stock's value to keep rising as the company grows. This approach can work, but it's also risky, as any stock or the overall market could fall drastically at any point.
Value investing, on the other hand, is a strategy where investors seek bargains, or stocks trading at prices significantly less than they are estimated to be worth. These investors focus on business fundamentals, such as cash flow, profit margins, and dividends. They also demand a margin of safety, which is what you get when you buy something for less than its intrinsic value. Warren Buffett is a value investor.
Cyclical vs. defensive stocks: Cyclical companies tend to react strongly to economic change. During a recession, consumers often put off large purchases such as a new car or refrigerator, which can temporarily depress the stocks of companies selling those items. Defensive companies are the opposite and are known as recession-proof stocks, by offering products and services like electricity, food, and medicine that people will continue to buy no matter the state of the economy.
Common stocks vs. preferred stocks: Individual investors typically buy common stock, which gives them the right to cast votes on company matters. Another form of stock is preferred, which usually carries additional conditions and often excludes voting rights. Preferred stocks often grow more slowly in value, but tend to pay higher dividends.
While there are between 3,000 and 4,000 publicly traded companies on U.S. stock exchanges, there are about 3,200 U.S. stock mutual funds. A mutual fund consists of pooled money belonging to lots of shareholders which is actively managed and invested by professional money managers. In exchange for the professional management of the money, shareholders are charged fees, which can be relatively low or as high as 5%.
Just as there are different kinds of stocks, there are different types of funds. There are mutual funds that focus on dividend-paying stocks, small-cap stocks, large-cap stocks, growth stocks, value stocks, or a combination of these.
There are also exchange-traded funds (ETFs), which are like a cross between mutual funds and stocks. They're funds that spread their assets across multiple securities, like managed mutual funds and index funds do, but they trade like stocks, with their prices changing throughout the day, instead of at the end of the trading day. There are ETF versions of many major index funds, such as the SPDR S&P 500 ETF (NYSEMKT: SPY), which is an S&P 500 index fund in ETF form.
Then there are index funds, which are passively managed, meaning they require little interference by professionals. Index funds are based on existing indexes (generally stock or bond ones) and they aim to hold the same components in the same proportion, in order to achieve the same returns (minus fees).
Index funds generally have much lower average expenses and fees than managed funds, and studies have found that over long periods, stock index funds tend to outperform the majority of managed mutual funds. According to Standard & Poor's, at the end of 2018, 85.1% of large-cap stock funds underperformed the S&P 500 over the past 10 years, with 91.6% underperforming over the past 15 years.
Stock investing: Pros and cons
The biggest advantage of investing in the stock market is that it offers a long-term growth rate that's hard to beat. Over many decades, the market has grown by an annual average of close to 10%. Of course, during your investment period, it might average less (or more). Here's how much you might amass if you average an 8% return and invest certain sums every year:
Growing at 8% for...
$5,000 Invested Annually
$10,000 Invested Annually
$15,000 Invested Annually
Here are some more pros to investing in stocks:
- It's easy to get into stocks. You can start investing in stocks as soon as you open a brokerage account and fund it with cash -- even with as little as $100.
- It's easy to get out of stocks. Simply place a sell order anytime to convert your equity back to cash.
- You stand a good chance of staying ahead of inflation, which has averaged 3% annually.
- You can collect income from your investments if you invest in dividend-paying stocks -- even when the economy is in a slump. (Dividend payouts from healthy and growing companies tend to be increased over time.)
- You'll be participating in and profiting from the growth of the American economy.
Of course, there are downsides to investing in stocks, including:
- You can lose money, especially if you don't know what you're doing or if you make beginning investor mistakes.
- If you want to be good at investing in individual stocks, there's a lot to learn, which takes time and effort. (Investing in mutual funds or index funds requires far less of you.)
- Investing in stocks doesn't work well if you tend to act on emotions such as greed and fear. For best results, keep a cool temperament.
- The stock market can be volatile, gaining 10% to 30% or more in some years and losing that much in others. (Over the long run, though, its direction has always been up.) When it comes to individual companies and their stocks, some can fall to zero in value.
What is real estate investing?
Real estate investing is familiar to most of us. It involves buying actual physical properties in one way or another. It can seem like an attractive way to make money, but while some properties do appreciate rapidly, much depends on location and timing, and plenty of properties grow very slowly in value.
Indeed, according to real estate researcher Robert Schiller, national housing prices averaged an annual growth rate of around 0.6% between 1890 and 2019. That number is adjusted for inflation, so if we add back an annual 3% inflation rate, the overall growth rate would be around 3.6% -- still well below the stock market's average of close to 10%.
As with stocks, there are various ways to invest in real estate.
The most familiar way of investing in real estate is buying an actual physical building, such as a home, often with the help of a loan -- a mortgage. Home ownership is the classic American dream, and out of all of the housing units in America, nearly 57% were recently occupied by owners -- those who owned the homes outright or had borrowed to do so -- while about 31% were rented.
Beyond the homes we buy for ourselves and our families to live in, many people buy additional property as an investment to rent out to others. Some investors own many properties and make a living from renting them out.
Another way that you can invest in real estate, typically with far less money, is via real estate investment trusts (REITs). They're companies that own real-estate-related assets, such as apartments, office buildings, shopping centers, medical buildings, and storage units. REITs are required to pay out at least 90% of their earnings as dividends. They aim to keep occupancy rates high, collect rents from tenants, and reward shareholders with much of that income.
With REITs, you can buy as little as a single share, often for less than $100, and have your money instantly diversified across a range of buildings. There's far less commitment than buying the property yourself.
Real estate mutual funds
Finally, you might invest in real estate through mutual funds focused on real estate. Each fund will differ in properties it invests in, but many own shares of REITs as well as shares of various real estate-related companies, such as homebuilders, home improvement retailers, and mortgage providers.
There are plenty of real estate ETFs as well. You may be able to get into a real-estate ETF you like more easily than some real-estate mutual funds, because some mutual funds may have steep minimum initial investments or may even be closed to new investors, whereas you can just invest in the ETF through your brokerage account and buy as little as one share.
Real estate investing: Pros and cons
Here are some of the key upsides to investing in real estate:
- The properties you buy or invest in can rise in value, making you wealthier.
- There are some tax breaks associated with real estate investing, such as deductions for mortgage interest on your home.
- If you invest in real estate, you may enjoy an income stream from collected rents.
And here are some of the downsides:
- Some forms of real estate investing require large sums of money and mortgages.
- It can be hard to get out of real estate quickly, as sometimes some properties don't sell immediately. This means it's an illiquid asset class.
- There's no guaranteed return, and plenty of properties fall in value in the first few years after purchase, with some staying underwater for a long time. (In real estate lingo, your mortgage is underwater if you owe more on your home than it's worth. In such a situation, you won't generate enough money when selling it to pay off the mortgage.)
- Being a landlord can be taxing, as you may have to deal with troublesome tenants and have unoccupied property at times.
- If you own properties, you'll be on the hook for maintaining and repairing them, and for paying property taxes and insurance.
Stocks or real estate -- what's right for you?
Given all of the above, between investing in stocks and investing in real estate, what's right for you? Well, for most people, the stock market will offer the best growth prospects over many years. That doesn't mean you shouldn't own or pursue owning your own home to live in, and it doesn't mean you can't also try investing in real estate. But remember that you can include plenty of real estate in your overall stock portfolio if you want to via REITs or real estate mutual funds.
Once you decide to invest in the stock market, what's the best way to start? If you have the time, interest, and ability to study investing, you might try investing in some carefully chosen individual stocks. But there's really no need to do so, because you can do very well with low-fee, broad-market index funds -- and you'll likely outperform most managed mutual funds while you're at it, too.
Even super investor Warren Buffett has recommended index funds for most people. He said he offers these instructions in his will for the money left to his wife: "Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard's.)"
Fund companies offer many index funds, so choose one with the lowest fees. A particularly easy way to invest in the S&P 500 is via an exchange-traded fund such as the aforementioned SPDR S&P 500 ETF Trust. A SPY share recently traded for about $297, sported a dividend yield of around 1.85%, and charged just 0.09% in annual fees. Meanwhile, the Vanguard Total Stock Market ETF (NYSEMKT: VTI) and Vanguard Total World Stock ETF (NYSEMKT: VT) will have you invested in, respectively, the entire U.S. market or just about all of the world's stock market.
If you're not already saving and investing for your retirement, now is a great time to start. Perhaps begin with a few shares of an index fund -- and then keep going. Most of us will need to have amassed a sizable nest egg on our own in order to retire comfortably.
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Selena Maranjian owns shares of AAPL, COST, F, NFLX, SBUX, and DIS. The Motley Fool owns shares of and recommends AAPL, NFLX, NKE, SBUX, and DIS. The Motley Fool has the following options: long January 2020 $150 calls on AAPL and short January 2020 $155 calls on AAPL. The Motley Fool recommends COST. The Motley Fool has a disclosure policy.