Although most investors can benefit from a diversified portfolio, investors often tend to favor either stocks or real estate. Although both types of investments can offer capital appreciation, income or both, they are quite different in terms of their overall characteristics.
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If you’re resigned to choosing only one option — either stocks or real estate — you should understand the risks and rewards that each type of investment provides. Here’s a look at the pros and cons of stocks and real estate so you can make a determination of which one better matches your investment objectives and risk tolerance.
Returns
Comparing long-term returns between real estate and the stock market is hard because each asset class has a wide variety of potential risks and rewards. However, the easiest comparison with the most data points is buying a house vs. owning the S&P 500 stock index. In this regard, there’s no real competition. Over the long run, the S&P 500 has returned about 10% annually to investors on average vs. just 3% or 4% for real estate.
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Volatility
Although stock market returns generally outperform real estate investments by a significant amount over the long run, investors have to pay a price in the form of volatility. Whereas housing prices may decline by double digits in a terrible year, the stock market can decline by 10% in a matter of days. During a bear market — which occurs about every 3.6 years on average — the stock market drops 36% just on average. In some cases, bear markets have seen stocks drop by 50% or more. This type of volatility simply doesn’t happen in real estate, except perhaps in the most extremely speculative portions of the market.
Liquidity
One huge advantage that the stock market has over real estate is its liquidity. You can literally sell any stock you want at any time of any day the market is open, and often after hours or before the market even opens as well. With most stocks, you’ll also enjoy an extremely active and liquid market where you can see the moment-to-moment fair market pricing for your stock.
If you’re selling a home, on the other hand, you might have to wait months or even years to unload your property, and you may never know what the “true” or “fair” value of your property is, as you’re subject to whatever a single investor is willing to pay you.
Investment Size
Investing in real estate typically requires more money than buying stocks. Whereas a piece of land or a developed property may run tens of thousands, hundreds of thousands or even millions of dollars, you can buy fractional shares of stocks at some brokerages for just for dollars. Some investment pools and publicly traded real estate investment trusts may offer lower initial investment costs, but owning a property outright typically requires a much more sizable investment than buying a stock does.
Leveraged Returns
Real estate can offer the benefit of leveraged returns. Although it’s true that investors can borrow against the value of their accounts to buy additional stocks — which is known as trading on margin — typically you can only borrow up to 50% of the value of your portfolio. But the traditional down payment on a home is just 20% of the purchase price, and many homebuyers put up just 10% or even less. This leverages returns and offers the potential for homeowners to earn a large percentage return on their initial investment. For example, if you put down $20,000 on a $100,000 home, you’ll double your invested $20,000 if your home simply rises 20% to a $120,000 valuation.
Taxation
Both real estate and stocks are capital assets, meaning they are taxed in the same way. Profits generated over one year or less are considered ordinary income, while those taken after more than one year are long-term capital gains, subject to lower tax rates.
However, real estate offers a wide range of tax deductions that are not available to stock investors. For example, if you own your own home, you can deduct your mortgage interest, home equity loan interest, discount points, necessary home improvements, mortgage insurance and property taxes (up to $5,000 for single filers or $10,000 for joint filers).
Benefits of a Diversified Portfolio
Both stocks and real estate are valid investment assets that offer different characteristics. For this reason, they can greatly complement one another as parts of a diversified portfolio. In addition to providing a place to live, residential real estate can offer a variety of tax benefits and the potential for long-term capital appreciation. Rental real estate can provide passive income in the form of monthly rent payments that typically increase annually, in addition to capital appreciation. Stocks are generally owned for their growth potential, but many stocks also pay dividends that also increase regularly, thereby providing the opportunity for income as well. The best course of action may be to own both asset classes in a diversified investment portfolio that you devise in conjunction with a financial advisor.
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