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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.

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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.

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