In Jeremy Siegel’s book, “Stocks For the Long Run”, he finds that real returns of stocks have averaged 7% since 1870. Real returns are returns after inflation is taken into account. For example, if inflation is 3% and a stock returns 10% in a given yr, then the real return would be 7% (10% – 3%). And real returns are the only returns that matter, because they measure an increase in spending power. If inflation is 3% and a stock returns 3%, then you haven’t improved your position at all. You can purchase exactly what you could purchase the yr prior. In conclusion, stocks increase in value 7% per yr because that is how fast companies tend to grow their profits.
Houses have their own version of profits: rents. These rents are profits, either realized if someone is paying you to rent the house or implied if you are not paying rent to live there. House prices and rents have been closely correlated throughout history, both increasing at the rate of inflation or about 3% a yr. This number is low because it is hard for a house to think up ways to increase its profits. Robert Shiller, the Yale economist who successfully predicted the stock market crash of 2000 in his book “Irrational Exuberance”, has found that home returns since 1900 would have been zero if not for 2 brief periods in history. Even if the two periods, one immediately following WWII and the other from 2000 to 2005, are included they would only boost real returns to 1% per annum. If you’d like to see his data sets, they can be found here: http://www.econ.yale.edu/~shiller/data.htm.
Many people are ill informed. They have seen the value of their home increase by leaps and bounds in recent yrs. They don’t consider long term returns, but rather their returns in the last 7 yrs. This isn’t nearly as accurate as using 110 yrs worth of historical data.
Some people argue that once the house is paid off you’re much better off – you’re living rent free. Well, that’s not quite the case. Its not possible for the house to be entirely paid off. Say you own a $300,000 house. The nationwide average for incidentals is 2%. That means even if your house is paid off, you’re going to spend $6,000 a yr on repairs and maintenance. And then there are taxes, which are at least 1% or $3,000 a yr. And then there is home insurance. Right there is $10,000 a yr in rent for a paid off home. $10,000 is not rent free. (Note: $10,000 is 50% more than I pay in rent per yr right now.)
Another important thing to consider is transaction costs. Transaction costs of houses far exceed those of stocks. I can buy $300,000 worth of stocks for $20. And it costs the same to sell that stock. So to get in and out of $300,000 worth of stock costs me $40. That is a negligible amount of money. But to buy a house it costs approx 1% of the houses value and to sell a house costs approx 6% of its value. That means to get into and out of a $300,000 house it is going to cost you around $21,000. That is a lot more than $40.
Right now houses cost 19 times their rent (or earnings). In other words, you’ll pay $19 for $1 dollar of rent in a home in the US. And homes rent will grow the same as inflation and/or 0% after inflation. Stocks cost 16 times earnings – you’ll pay $16 for $1 of profit in the average US company. And the average company will grow its profits 10% a yr and/or 7% after inflation.
Bottom Line: Which would you rather have in your portfolio, a house with a P/E of 19 that will grow profits by 3% or a stock with a P/E of 16 that will grow profits by 10%?
Note: This argument is a bit simplistic, I will write a more detailed argument considering leverage, etc in the next day or two.