The Beardstown Ladies

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People are cognitively very, very bad at taking all costs into account when calculating investment returns. In one haunting example from a New York Times article on real estate, one investor illustrates this perfectly:

By comparison, he views the four-bedroom home he bought for $32,500 in 1965 – or about $200,000 in today’s dollars – as a money tree. He and his wife recently listed it for $413,000. That would translate into an annual return of 1.2 percent, taking into account inflation and the cost of two new decks and an extra room.

They plan to move to Texas after it has sold. “I wish I’d bought more real estate,” Mr. Larson said.

Regular readers of iwillteachyoutoberich will know that you could earn several times the 1.2% return simply by investing in a simple target-date fund or index fund. We’re not properly wired to calculate all costs of our purchases; in this case, taxes, and all the other costs of buying a house.

Sadly, Mr. Larson truly believes that he got a great return.

* * *

When I recently asked “What are areas where people THINK they earn a lot, but actually don’t?” iwillteachyoutoberich reader Baron wrote a fascinating comment about a group I hadn’t heard of before.

“individual stocks. ever heard of the beardstown ladies? they thought they were performing as well as warren buffet. when the accountants went through their numbers, they actually underperformed the market. people screw up accounting all the time whether it’s stocks, real estate, or some other investment.”

This was news to me, so I dug around. From Wikipedia:

The Beardstown Ladies were a group of older women who formed an investment club, formally known as the Beardstown Business and Professional Women’s Investment Club, in Beardstown, Illinois, USA.

In 1998, an article in Chicago magazine asserted that the group’s stated returns had included the new investments made by its members, and that when computed in conventional fashion, their annual rate of return for 1984–1993 was actually 9.1%, considerably less than the 14.9% return on the S&P 500 during the same period.[1] Outside auditor Price Waterhouse, hired by the club, confirmed the sub-par 9.1% annual rate for 1984–1993. The auditor also discovered the Beardstown Ladies’ annualized return was 15.3% when all of 1983–1997 was included; this was better than the average stock fund at the time, but still worse than the S&P 500 return of 17.2% for the same period.

Here is a great article on the group, and a followup article from the WSJ.

Key takeaways:

  • “Investing” does not mean picking individual stocks. Few people can pick stocks and beat the market. Nearly no one can do this with regularity. Instead, as a general rule, invest in low-cost target-date funds.
  • Let’s break this down by smart, ordinary, and dumb people: Very dumb people don’t read this blog, so they don’t even think about this and we don’t need to waste more time on them as a category. Moderately intelligent people also generally ignore personal-finance advice, or they may eventually listen. Whatever. Let’s talk about smart people. Smart people generally believe and adhere to the evidence that you can’t beat the market. But here’s the twist: Ironically, HIGHLY INTELLIGENT people believe they can out-smart this advice — and the equally smart people on Wall Street, who also fail to beat the market — and invest in individual stocks anyway. They pay the price — though they may never realize it.

In my book, I do an exhaustive review of so-called experts and show you sophisticated tricks that Wall Street uses to trick you into believing they perform better than they actually do.

Read several book excerpts here.

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68 Comments

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  1. So we know Mr. Larson made a poor investment decision, but when we factor in the costs of an alternative (sunk costs from renting/leasing other homes/apartments), is it still a net loss? In this scenario, perhaps his decision was still the right one.

    • It’s a net loss compared to other places he could have put his money (e.g., the market).

    • Jameson Triplett Link to this comment

      There are a number of cost factors here that are being ignored in the house equation. I’d be willing to make a bet that a long term commitment to a house, 20 years, or so, would net about the exact same return on gross wealth as renting and putting any difference in cost into a fund. Plus you have a happiness factor built in. I’ve done the numbers out a few times in my own home purchasing conundrum. If you assume about 2.5% growth in Asset value, it nets out to almost free rent for the time you were living in the house, +/- depending on assumptions.

    • I agree with this. If he COULD put what he was paying for his mortgage into something with better returns, that’s obviously better. But everyone has to pay for housing, so if you have to pay $800 (or whatever) a month for housing whether you bought or are renting, then 1.2% return is better than the 0% return that you’d get renting. Of course this is oversimplified since it doesn’t take into account house maintenance, property tax, and a lot of other factors, but it’s also too simplistic to say “1.2% is a bad ROI on your $800 a month” because it doesn’t take into account that you HAVE to spend that $800 a month on putting a roof over your head, you don’t have the option of sticking it in the S&P 500

  2. I knew about the Bearstown ladies but didn’t know about their Enron-like accounting! Just kidding…but this now disproves hundreds of articles I’ve read trying to get people to pick individual stocks. Now if the Sun Times monkey is discovered to be a fluke we are really on a roll…

  3. This doesn’t seem like a fair judgment of the Larson family. Pulling a post-inflation profit of 1.2% on your *dwelling* is an excellent return, especially if you account for the comparable cost of renting (which your linked NYT article does for another investor). Investors who do “buy more real estate” tend to rent those properties, increasing returns. As an investment, real estate can certainly be complicated to evaluate, but that doesn’t mean we should collectively throw our arms in the air and tell them to just go buy stocks like a smart person.

  4. to add insult to injury, since a lot of people account for their investment gains poorly, they probably pay taxes on income they never made.

  5. I think you could be shortchanging the Larsons signficantly. That 1.2% return may adjust for inflation, but it also assumes that the Larsons paid cash for their home. If they only put down 20%, then that would multiply their rate of return several times over. It’s that ability to easily leverage your dollars that can make real estate such a lucrative investment, albeit (as we’re seeing) a risky one.

    Also, bear in mind that the Larsons have lived in Minneapolis, a perfectly nice place to live 2 months out of the year that hasn’t seen a lot of growth in the last several decades. The truism about real estate being all about “location, location, location” is key here. If they had bought their house in Los Angeles, or San Francisco, or Miami, or New York, their rate of return would’ve been significantly (even astronomically) higher. So long as population growth continues, and those places keep attracting people and businesses, they will see good real estate appreciation. Before buying, then, one should at least take in to account the current prospects of your local economy and the desirability of your location.

    Finally, the fact that real estate correlates so closely with inflation could be a real selling point for some. If you’re someone looking for a good inflation hedge right now, a 30-year mortgage on a house at a sub-4% interest rate is looking pretty good.

    • “So long as population growth continues, and those places keep attracting people and businesses, they will see good real estate appreciation.”

      Straight from a real estate agent’s mouth to the blog comments here, I see.

      I live in North County San Diego. We have possibly the best climate in the entire country. Cool ocean breezes and 60-75 degrees year round. A couple months of rain. Earthquakes that make things exciting. ;)

      Anyway, my point. We moved here July ’09…not that long ago. Our house (which we rent because we’re not idiots) has dropped in value from $975,000 to $850,000 during that time. It hasn’t even been a year.

      Plenty of people bought “million-dollar” houses here last year that are now worth only $750,000. Whoops.

      It happens all the time. Whenever it’s cheaper to rent than buy in the same neighborhood, RENT! I expect prices will drop another 30% or so here over the next few years. They sure did in the rest of San Diego.

      -Erica

  6. 1.2% gain on the full purchase price of real estate is very fine.

    1) You borrow 75% or more, then the rate becomes closer to 6%
    2) You live without paying rent, or you collect rent, which is probably another 5% when you buy but after 40 years of inflation that could be maybe 100% on the original investment.
    3) You have the ability to borrow against the full market value of the house thereby accessing the cash tax-free, saving another 30 or 40% in taxes for money you could use to buy other investments.

    Total benefit of a smart real-estate purchase blows away any retail mutual fund purchase. It’s the same with any business, if you own the actual business you’re ahead of the guy who owns a retail representation of the business that has been packaged and skimmed by middlemen.

    • “You have the ability to borrow against the full market value of the house thereby accessing the cash tax-free…”

      Are you seriously suggesting taking out a HELOC in order to invest in other things? I suggest you watch “Kitchen Nightmares” and see how many of the people on there did that, invested in a restaurant that is now failing, and stand to lose their house. That story plays out in at least half the episodes.

      If you invest in a mutual fund in a non-retirement account, you don’t have to borrow against it…you can just SELL it when you need the cash! It’s liquid, unlike real estate.

      Even in a retirement account, there are scenarios where you can withdraw some of your cash with no penalty.

      Ramit, I think your blog has been taken over by realtor- real estate broker bots. :(

      -Erica

  7. It seems like this doesn’t really take into account everything that’s happening though. They did get at least a bit more return (if not monetary return) from living in the house for 45+ years. You would need to be spending money anyways towards some sort of shelter (rent or buying, that’s to be decided), but who is to say that they could’ve invested all of that money up front?

  8. Well what about the up to $500,000 income tax exemption they will recognize?
    Not to mention the 45 years of mortgage interest tax write offs?

    Meaning when they sell they will owe no income tax. The index fund would have generated a huge tax burden. Then they would have had to rent for 50 years.

    Somebody want to do the math?

  9. Was it his personal residence or an investment? I don’t think any personal residence is an “investment.” It’s your personal residence. Period.

    Now if it’s an “investment” and he’s been renting it out all of those years, it very well could have been a cash cow…even including the cost of the deck and everything else.

    I think it’s silly if folks try to calculate their return on their personal residence. You didn’t buy that home as an investment, you bought it to live in.

    Just my .02

    Carey

  10. As everyone is pointing out, there are a huge number of factors which can make a big difference on calculating return on your real estate. The point is, too many people buy too much house with the justification that it is an “investment.” Or worse, they consider it an investment and that’s all they do!
    I like that about the Beardstown ladies because any story emphasizes the need to keep good records and to know how to read and interpret them makes me feel warm and fuzzy all over.

  11. They plan to move to Texas after it has sold. “I wish I’d bought more real estate,” Mr. Larson said.

    So I wonder if he said this before or after they told him what his true rate of return was over that time span. I’ve been in the mortgage industry for many years, and I’m slowly moving towards this notion that only specific real estate is worth calling an “investment” and that the misconception of all real estate (presuming the market isn’t taking it on the chin) being an “investment” is running rampant more than ever.

  12. This ties in with my comment on the bad investment post about college. I see people consider the cost of tuition and then parrot that college graduates make x% more than high school grads so it’s a good investment, but what you don’t see is people calculating the opportunity cost of college, including the amount of money you would make working full-time two or four years and the experience you would gain. Obviously, if you’re getting a real degree at an accredited university this doesn’t really apply (some people on the last post started talking about how valuable their MBA is – I agree with you!), but pretty much all of my cousins have graduated with a degree they don’t use, they don’t plan on using (and probably couldn’t if they wanted to anyway), and have all gotten entry-level jobs that they simply do not need their expensive degrees for. So why did they go into debt in the first place?

  13. “Whenever it’s cheaper to rent than buy in the same neighborhood, RENT! I”

    To clarify, how do you determine if it is cheaper? Do you look at mortgage payment versus rent, or do you consider all the factors which go into the real cost of shelter (principle payments, tax benefits, prop taxes, maint, etc….). It is important to consider all of the factors to really determine which is cheaper.

    “Anyway, my point. We moved here July ‘09…not that long ago. Our house (which we rent because we’re not idiots) has dropped in value from $975,000 to $850,000 during that time. It hasn’t even been a year.

    Plenty of people bought “million-dollar” houses here last year that are now worth only $750,000. Whoops. ”

    Seems like their are plenty of people who think they can time the real estate market as well. I think this falls under the whole market timing argument – cant do it in real estate and you cant do it in stocks.

    • Unlike the stock market, you can figure out when to buy or rent a house.

      If it’s cheaper to rent the same house than to buy it, rent it.

      The NYTimes has a great calculator here:
      http://www.nytimes.com/interactive/business/buy-rent-calculator.html

      Ramit has referenced that quite often, as well.

      In my neighborhood, given current prices, it’s “never better” to buy than to rent according to the above link. That’s why I get a bit nuts when people buy houses in this neighborhood! It’s a poor financial decision disguised as an “investment.” And yeah, I get riled up about it.

      My landlord, who bought this house in 1994, is doing exceptionally well. If we revert back to the same price/rent ratios we had in 1994, I’ll definitely consider buying a house. But prices are still highly distorted here. Until owning is cheaper than renting (and not just with a huge down payment), it’s a bad idea to buy because prices will drop. That’s not “market timing”; that’s common sense.

      -Erica

  14. The math:

    First, this will be based on Chicago figures, as that’s where I live and it’s where I’m most familiar with the real estate market. Also, I’ll run a condo-vs-apartment comparison, as that’s where we’re most likely to see similarities in product quality; there’s no sense comparing a detached SFH with an apartment in a big building.

    So, a 2-bedroom/1-bathroom condo in Chicago (in a decent area) runs at somewhere between $230,000 and $250,000. Call it $230k after negotiations and closing costs. Put up $46,000 in down payment to avoid mortgage insurance and finance the $184,000 balance.

    A 30yr fixed mortgage at 5% runs just about $1000 per month, which is pretty competitive with the rental price of a comparable apartment, which itself would run closer to the $1300-$1400 range (for a condo-quality 2br, which I know because I happen to be a leasing agent in Chicago). After negotiations call it $1300.

    Now, to be fair, homes have repair and tax costs at about 3% of their purchase value per year, so tack on an additional $575 in costs per month. A $1,575 home ownership price tag is pretty steep alongside that $1300 rent rate!

    The difference in rent versus mortgage ($1575-$1300 = $275) is where we really need to focus, because that’s your true “cost” of home ownership (plus your down payment). We can get into gritty details about principal vs. interest and all that nonsense, but at the end of the day we’re looking at that little bit of extra cash.

    If I were to invest my $46,000 down payment into the S&P and add an additional $275 per month to the balance, I could expect to have an $800,000 asset after 30 years (the inflation-adjusted CAGR of the S&P over the last 30 years has been 7.43% – but it’s worth noting that over the last 50 years it’s only been 5.27%).

    By comparison, that same home can be reasonably expected to sell for about $565,000 in real dollars (based on a 3% after-inflation appreciation rate).

    That’s a pretty substantial hit, all things considered.

    The most obvious problem I see with this analysis is actually the type of home being purchased. If you’re going to buy a 2-bedroom condo to live in for 30 years, this is a bad investment. But if you want to own a two-level, 4-bedroom house with a yard, your only reasonable option is to buy; renting the equivalent becomes ridiculously expensive because there is very little market competition in that price range (expect a $3,000 rent versus a $2,000 mortgage).

    Anyway, that’s my $0.02.

    • Hi Chris,

      The problem with condos is HOA fees. They can run several hundred dollars a month in some condos, and unlike the mortgage, they don’t go away in 30 years. Condos can also have “assessment fees” that can run into the tens of thousands of dollars. These aren’t often talked about in the buy vs. rent equation.

      -Erica

  15. I always like to check the math on these things because the irony of getting math wrong in an article on bad math is so wonderful. That 1.2% return is calculated _after inflation_. Since the authors assume that $32500 in 1965 is equivalent to $200k today, that means they’re assuming 4.1% annual inflation, which means that his real rate of return is 5.3%. After all, you _always_ have to pay for inflation. The S&P 500 annual return from June 1, 1965 to June 1 2010 was 5.7%. That is all.

  16. What drives me really crazy is people justifying buying a bigger house because it is an “investment”. Better to buy the smaller house and invest the rest in the market or other real estate that can be rented out at a decent rate.

  17. @Chris Caton

    Don’t forget to account for the effect of inflation on the $275. One of the biggest advantages of owning a house is locking in a housing cost for 15 or 30 years (whereas rents tend to track inflation…as they should). In other words, the owner pays $1000 (plus extras) every month for 30 years, while the renter’s rent (theoretically) increases with inflation. So at some point, the renter’s $275 advantage disappears, and in fact the owner is paying less in housing costs than the renter. Depending on your inflation assumptions, this can have a material impact on the final outcome.

  18. In follow-up to my first comment…that’s not to say that buying is always right. I think Ramit’s advice is generally right here – do the analysis, plug in YOUR parameters (not out-of-the-blue assumptions) and see what makes sense.

  19. @Wes:

    Yes, you’re absolutely right. Renters do run into a few problems in that regard. In theory, the homeowner’s base cost of living decreases constantly. At some point I’m going to have to run the math on that analysis. It’s such a great observation and it should be included in some big spreadsheet or something.

    • I’ve built the model, and should one day getting around to posting a desensitized version on the interwebs. It’s tricky, because things like property taxes and home repairs ALSO follow inflation.

  20. Erica Douglass, you certainly have the IWTYTBR attitude down pat. Arrogance oozing from every word; contempt for anyone that does something different than you. I’m suddenly remembering why I rarely visit this site.

  21. There’s so many flaws to this logic, it amazes me. This is a very complicated calculation, and so sum it up in a few paragraphs just isnt possible. ONE of the biggest mistakes is assuming that your rent wont go up with inflation every year too. And obviously it would! If i rent a place for a 1000 today, how much is that place going to cost me in 25 years? But if you lived in the same place, ur mortgage should never go up. So at some point, the cost of owning a house on a yearly basis is actually cheaper then renting. And what happens when ur place is paid off in full and u dont have a mortgage now.

  22. if you purchase a house and pay it off in 15 years and then invest the same money you were paying on your mortgage you’ll end up ahead of the renter (who pays rent their entire life) 99 times out of 100

  23. DanP – I think we’re both fighting a battle we’ll never win with Ramit. He’s convinced himself renting is the best option and I don’t see him ever saying differently, even if basic math backs up your argument.

    • I don’t agree, Matt. As I’ve written in my book and on this site, there are a lot of reasons to buy, and money is one of those reasons. But too many people blindly make the biggest purchase of their life without running the numbers, instead defaulting to vague words like “tax deduction” and “pride of ownership” without fully understanding the ramifications of purchasing. But I’m a big fan of conscious spending, whether it’s shoes, jeans, travel, or…a house.

  24. @bill – agreed. If your website bio says. ‘When I was 26 I sold my business for $1.1M’ then you’re a loser. Just like when you ask someone what they do and they say, I’m blah blah and I make $150k a year. Unless someone asks you how much you make don’t advertise it.

  25. @erica – if your mutual fund investment goes down after a year do you consider that a bad investment? do you sell it all right away? by your logic you would. the arrogance you show in your posts is appalling.

  26. Everybody chill on the name calling. Let’s keep it civil.

  27. Very interesting. Reminds me of the book: A Random Walk Down Wallstreet. It’s all in the numbers…

    yupfin.com gen-y’s financial plan

  28. I think people are missing the point. This article opens with: “People are cognitively very, very bad at taking all costs into account when calculating investment returns.” It was not, “Real estate is a terrible thing.” In fact, Ramit never says that, and the second half of the piece has nothing to do with real-estate. I think his point is not that real-estate is good or bad, it’s that people make large financial and investment decisions without thinking them through. Without /really/ thinking it through. Conscious spending. Conscious investment. Ramit doesn’t rip on people who “waste” money on shoes, going out, shopping, or whatever, he only rips on people who spend blindly and complain about their financial situation without putting /real thought/ into it. That’s the whole point. Not to fit a mold or “do this” “don’t do that”, just “THINK!”

  29. Hey guys, there’s a very important point Ramit and Erica are trying to get across: run your numbers BEFORE you buy! They’re not saying to never buy a house, just make sure you do your homework before buying it. It’s the biggest purchase of your life, and if you don’t at least run the numbers through the NYTimes buy vs rent calculator, you might be throwing money away.

    There are obviously a lot of factors to consider when calculating, so it might be financially better to rent, or buy. Just talking about it without doing the number is pointless. Most of the arguments here could be valid, but again there are other factors that could offset them.

    Also, when you buy a house, you tend to spend a lot more money decorating and improving it, and you might sell your house to get a bigger one afterwards. Most don’t think about those when they buy the house. All these indirect costs might add up to a significant chunk of money.

    And the website bio thing has nothing to do with the conversation here, and Erica obviously is just listing her experience/background on her site, why wouldn’t you tell your readers that you had a million-dollar company? It tells others that you know what you’re talking about, and that you’re not a fake. It’s just like what you would put on your resume. And she’s just trying to share her own experience instead of being arrogant.

    All in all, I’m convinced that buying might not be financially better than renting sometimes. Just keep your mind open to it and you will put your hard earned money to great use!

  30. Someone else probably already mentioned this, but Ramit’s calculation of a 1.2% is WAY off. That’s assuming he purchased the home as an investment, but it wasn’t an investment. He LIVED in the house – you can’t live in your stock investments! If you are comparing the 1.2% return to what you would’ve gotten in the stock market, you need to deduct a couple grand per month from your stock gains to properly account for the fact that his house was his primary residence.

    • You also need to add 40-50% to the sticker price of a mortgage each month (amortized over loan) to account for maintenance, taxes, etc — and that doesn’t even include increased spending due to the hedonic treadmill.

  31. As quite a few people have pointed out, Mr. Larson’s “investment” in his home is not nearly the bad investment that Ramit suggests. Mr. Larson and his family have to live somewhere. Now they could rent for thirty years and make the landlord rich, or they can buy that house, keep it in good condition and sell it for a profit when the time comes. This is something they can’t do if they rent. I’d rather have a “1.2%” increase when selling my home than a 0% increase when moving out of a rental. If your idea of a good investment is paying off your landlord’s properties, then go for it. Me, I’d rather know that the money I pay each month to the bank for my home is going towards the equity in MY home, not someone elses.

    • Your comment is only a good assumption when renting and owning are the same price.

      Here, I rent for x, and could own for 2x. In that case, renting for x and saving/investing the other x will return far ahead of owning and “throwing my money away” in interest to the bank.

      -Erica

  32. One of the important points that has slipped through the cracks of this discussion is Larson’s comment that “I wish I’d bought more real estate.” While there is some merit to both sides of the rent v buy argument for your primary home, it seems quite clear that buying additional INVESTMENT property and achieving a 1.2 percent return on it would have been a mistake. Ramit’s point that people don’t understand their costs is very relevant hear – Larson appears to not understand the effect that inflation has had, nor the forgone opportunity costs of having invested additional dollars in real estate. Had he instead invested in equity index funds, he would have done far better.

    On the question of renting v buying a primary home, I agree with Ramit and Erica that, contrary to the conventional wisdom, renting often is financially advantageous, at least for short periods of time. However, it is quite unlikely that Larson would be wealthier today had he spent the last 45 years renting his home. If you stay in your home long enough and it appreciates anywhere close to the historical average of 0.4% above inflation, owning will virtually always beat renting.

  33. Well another aspect being over looked is this.

    I buy a place for 200k and put town 20k. We’re comparing the returns on 20k in the markets, or in real estate. But that’s not true, we have to consider in the markets we’re looking at returns on 20k, in real estate, we’re looking at returns on the 200k as this is technically a leveraged play against real estate.

    While i entirely agree that most ppl jump into homes without thinking and assume its the “smart” move, for anyoen to say taht buying a house is a bad idea…well that’s just as missinformed as saying buying a house is always a good idea.

    • “for anyoen to say taht buying a house is a bad idea…”

      Yeah. I’m sure Ramit will NEVER, EVER, EVER buy a house, because he thinks it is always an unequivocally bad idea. No exceptions.

  34. I read the Beardstown Ladies story before it was found that they had really underperformed. It was an eye opening experience for me, because I had really been in awe of what they had done together….until we found out the real numbers. Good lesson is to dig down to the real numbers, and trust your gut. If the story sounds too good to be true, it probably is!

  35. I do like some of the advice on this site, but I do believe it is possible to pick “pick stocks” or day trade or even swing trade and make money.

    I have been able to make money the past 2 years in the stock market doing just this. The key rule is to make sure you are disciplined and have a plan ahead of time for what you want to trade, then execute that plan without deviating even a little.

    It can work – as long as you have the discipline, forget about your (emotional) relationship with money, and learn about the stock market and devise your plan from that knowledge.

  36. I’m glad a number of commenters picked up on your oversight re: real estate.

    It is important to remember that real estate is an asset that can provide a financial return BUT IN ADDITION provides the service of housing (a substitute for paying rent), not to mention some tax benefits.

    It is not valid to compare his return on real estate to other investments like an index fund. He’s got to live SOMEWHERE! Is the return from the index fund enough to pay his rent? I doubt it.

  37. Totally agreeing with SeeingFinance’s comments; as well as many others with a similar view about the benefits of real estate providing housing and being an asset. Numbers are great; there’s no denying. However, big return or not, there’s no place I’d rather live than my little bungalow. I love owning my home for some many reasons (including the significant amount of equity I have; the stability I feel in having a nice place to live that I maintain and take personal responsiblity for; and the interest tax write off.) Yes, many of the reasons are purely emotional. Interesting that Ramit never discusses the important emotional aspects of homeownership.

  38. I think the biggest question that people are missing is “How long do you plan on living in the residence?” The problem is that we’ve become a mobile society, moving on average once every 5 years. Hint, that’s the five years that you pay the most in interest, fees, and up-front costs on any house you buy. However you look at the “equity” in a house you own, don’t even factor that in to the conversation unless you plan on living in that residence for at least 5 years.

    If you ask this question in the beginning, then you can save yourself a lot of grief doing calculations. It is almost always better to rent than buy if you don’t plan on living in a particular location more than 5 years. Plus, factor in the headache of selling a house versus leaving a rental property after the lease is over and it becomes a no-brainer. Also, consider the fact that you lose another 10-12% on the back end of your housing “investment” when you sell a house (6% real estate agent fees and 4-6% in other closing costs and repairs, etc.), and the picture becomes even clearer. Selling a house is a rip-off in the US, considering that agent fees are less than 2% in many other countries.

    Now, buying a house as an investment to rent out could be a smart decision if you:

    A. Make a smart purchase
    B. Plan on keeping the property for a long time
    C. Get lucky and have good people to manage and maintain the property

    Hope this helps…

  39. Ramit,

    I agree with you about people not understanding the real return of real estate. However, I agree with others here as well that point out that there is additional value to the home above the “investment” (which it isn’t…it is much different). I wish you would have included the two paragraphs above the one you did. They provide some different insight:
    Beyond the shelter it provides, the biggest advantage of real estate might
    be that it protects people from their worst investment instincts. Most
    people do not sell their house out of frustration after a few months of
    declining values, as they might with a stock. Instead, they are almost
    forced to be long-run investors who do not try to time the market.
    An interesting thought. By buying a home you don’t lose your butt in the market. (But, we would never try to time the market, because we read this blog.)

    Harlan Larson, a retired manager of car dealerships near Minneapolis, still
    regrets having bought Northwest Airlines stock at $25 a share a few years
    ago. It is now trading at less than $5.

    However, Mr. Larson doesn’t read this blog. Imagine how much less he might have had if he hadn’t bought the house — he would have been picking losers!! When he did…he lost his rear end. Again, another example of “you can’t pick stocks, so don’t try to do it”.

    Back to the house calculations. If we assume he put 20% down, had a 20 year mortgage at 7%, put on the extra room at a cost of $5,000 in 1975 (we don’t know truly when or how much he spent… but I assume this as by then he probably needed room for another child). If he put on one of the decks the year he paid it off (1985) at a cost of $1,500 and put on the next deck in 2002 at a cost of $3,000, then his rate of return, before inflation is 6%. That would make it a roughly 3% return after inflation. So, he made 3% per year and got the benefit of shelter, no common wall with neighbors as he potentially would have had in an apartment, etc.

    Of course, he had additional outlays of capital for taxes, etc., but in a rental situation he would have had these too — they would have been built into the rent.

    So…3% a year after inflation. Not bad for something that isn’t truly an investment. If I can make this equivalency on my house sale in 40 years, I’d be very happy. But, I’m not viewing my home as an investment. It is shelter and a place where my wife and I are creating memories — hopefully with a family later too.

    • Add’l calculation — if you assume he was in a 20% tax bracket for the years he paid his mortgage and he had enough to itemize, then his rate of return increases to 6.39% or 3.39% after inflation.

  40. The thing that tires me on these discussions is the fact that there is no ‘right’ answer for everyone. Personally I love owning since I’m pretty handy, whereas it might not make sense for someone else who is not. Instead of arguing you are throwing money away doing buy|rent, the more important consideration is you’re not screwing yourself by buying|renting more home than you should.

    I’ve seen friends get in trouble both ways, neither is a guarantee.

  41. Renting vs. Buying…It’s really more of a situational decision that cannot be addressed in a paragraph or two. However I think the point to remember is that generally over the long term housing tracks inflation plus a percent or so. This in and of itself is not a great reason to park your money in a house and should shatter the idea that your making substantial money on your home.

    The way I read the blog post, the argument isn’t that Mr. Larson should have rented but that Mr. Larson should realize that his house was not a phenomenal return. Nowhere do I read where Ramit is wholesale against buying.

    That being said there are a lot of benefits of homeownership that are really outside the realm of financial analysis. I find that my house gives me some privacy I never had in my apartment. I have a fixed rate mortgage so my only cost variable is property tax, and there is something satisfying about laying on the grass on your front lawn knowing that there is no landlord to answer to.

  42. I agree that renting versus buying is a decision to be made based on a lot of factors and your personal situation and desires. The question of whether or not Mr. Larson made money off the deal and how good an investment it is has also lost sight of the fact that when he would have bought the house in 1965 there weren’t loads of easy investments available to the average middle class guy. Did purchasable index funds exist then? I know trades through a brokerage house cost a lot more than $5 or $10, and to get anything you would have pretty much had to have gone to a brokerage house since computers in the home were decades away. Sure, he could have been the odd man out and gotten into investments and trading, but I know none of the families I grew up around had parents who bought or traded stocks. You put your money in your house, the bank, and if you were lucky a vacation property. Where else did the average middle class person have to really invest in 1965? Bonds? Treasury Bills? Would he have been much better off with those? Also, at that time they would have had a harder time qualifying for the mortgage, and wouldn’t have gotten the inflated BS others have gotten in recent times. So his mortgage would have aligned better with his income and would have been a better deal for him overall compared to renting.

    So to me he did okay, not great, but okay. He invested in what he understood, and has made something out of it. A take away I have is that he did something with his money to earn something, we can argue all day about the “best” thing to do, but if he hadn’t done anything he wouldn’t be in a position that many folks would envy today.

  43. I am not sure whether its really relevant to this discussion( but going by key takeaways it is I think), but buying index or index related fund is probably best in mature economy like US, but in growing economies like India( I am from India so….) there are easily identified opportunities outside index(so called mid cap), so it makes sense to find something beyond index. If not individual stock picking at least picking a good midcap or extended index fund will give you better returns.

  44. Man, this is getting heated. But seriously, have y’all visited this site before when Ramit talks about his savings breakdown? Because guess what’s on the list? A house downpayment. He’s not anti-house buying. He’s anti-house-buying for emotional or cliche-but-totally-wrong reasons — e.g., OMG I’m 25 and I’m going to be living here for at least two more years, and I’m just throwing away money on rent so of course I’m going to buy this awesome condo!!!

    We are sociologically conditioned to want to buy houses. It’s a celebrated adult step, like getting married or having a baby. But it isn’t really always in our best financial interest. Ramit just wants everyone to think more like an economist when it comes to making huge financial decisions like house-buying, so you don’t wreck your financial future on an emotional whim or bad accounting.

  45. Guys,
    You are missing the point! If you buy property (for personal use or investment) you accumulate capital by repaying the debt and if you choose wisely you might make some capital gain. However, the most important aspect is that in 10 years, the house is paid off!!!!!! In addition, you have the capital as equity. If you are renting, you will pay rent until the day you die and will have nothing. So, although renting will be cheaper in the beginning, there will be a break-even point- when rentals through inflation adjustment and price escalation have caught up.
    Yes, there is opportunity cost. If you own property worth $1m, it does not pay rent or interest (at least not market related).

    Hope this helps.

  46. Mike Hernandez Link to this comment

    I bristle at the notion that investing in individual stocks has anything to do with intelligence. That’s the way I’ve been doing it for 12 years (after a former teacher gave me ben graham’s books for christmas), and while I haven’t hit any grand slams, I’m doing significantly better than if I’d plowed the same money into an index fund. It’s not a lottery, kids. I’m willing to put in the time and effort it takes to make my picks. Does that make me dumb? No–just unwilling to settle for mediocre returns.

    • Mike, if you’re beating the market, congratulations. You may be one of the extremely rare people who consistently does so. Unfortunately, history and hundreds of studies have shown that beating the market over the long term is virtually impossible, so I have to respectfully disagree on investing methods. (I cover these studies in extreme detail in chapter 6 of my book.)

  47. [...] has talked a lot about decisions, and why people make so many bad ones when it comes to money. But for all the poor choices we regularly make about our finances, we often [...]

  48. So after reading this and the following comments, I wonder where my parents should stand in this. They are currently renting and and the next 2-5 years would like or buy or build a house – one in which they plan to live in until they die or are sent to a retirement home. Would they be better off finding the perfect place to rent for the next 25+ years or building/buying their own home? What does their investment mean for me when they pass away?

  49. If you get a house/condo/apartment that’s less than 20 times the annual rent and the mortgage is less than 30% of your take home pay, then go buy the property for self-occupancy..else pass the opportunity… there are plenty of apartments that are available that will meet the criteria mentioned above.

  50. I agree that the alleged house appreciation isn’t spectacular, but this may be an oversimplification of the life of ownership of this house. Let’s say the guy put down only $10,000 on the house, and the guy he bought it from carried the mortgage at 5% interest. Then he turned $10,000 in to $400+k. It also might have been that if his mortgage was favorable to rent, especially with the interest deduction on his taxes. I mean, my mortgage rate is 5 1/4 but with the deduction I’m guessing it’s closer to like 4%, and I’m probably paying about what I would pay to rent my condo.

  51. Complicated one!

    Take for example the show flip it, or flip that house etc;

    Buy house 100k
    cost of renovation 20k
    sell house 200k
    profit 80k
    Everybody lives happily ever after.

    Reality

    Buy house 100k in Canada where I live, with little of own money.

    Pay property purchase tax, CMHC mortgage insurance for high ratio mortgage. Purchaser is self employed, must be because he’s working on the house every day. So factor in some big fees because he’s a risk to the lender. Legal fees. 10k

    Spends the next 3 months day and night renovating at say $30 ph for his labour and project management fees. Say 60 hours a week x 12 weeks = 20k

    Materials, kitchen bathroom paint etc… 10k

    Pay some specialty trades like plumber and electrician 8k

    Mortgage carrying costs for 4 months (3 to reno and 1 to sell it) 7k

    property tax and utilities for 4 months 1k

    buy some tools that you didnt think youd need and misc costs 1k

    Put house on market- realtor fees 12k

    legal fees and house staging 2k

    Total costs 81k

    Bought for 100k
    spent 81k
    sold for 200k
    net profit for all the risk upheaval and hard work 19k

    Tax man says thats not your principal residence so deduct capital gains tax from the 19k and the 20k sweat equity you put into it.

    Think… well could be worse and then see that there is a huge mortgage penalty to get out of the mortgage early.

    I know this can happen as I did a similar thing myself, I managed to pull out of the nose dive by finding a private sale and the buyer assumed the mortgage, so I avoided the huge penalty and realtor fees.

    Really wasn’t worth the huge hassle that it became.

    Could easily be, market drops or house sits on market for months you paying the carrying costs and then you really lose your shirt!