“If you don’t find a way to make money while you sleep, you will work until you die.” ~Warren Buffet
If I asked you to explain to a 5th grader the basics of how people make money investing in real estate, you probably wouldn’t miss a beat: buy a house, collect rent, subtract your expenses and the rest is profit. Have the average person try to explain how the stock market works however and the answer will likely be about as helpful as asking Kim Kardashian to give her interpretation of campaign finance reform.
This lack of clarity causes people to see the stock market like a casino instead of a rental property. If you feel more like Kim Kardashian than Warren Buffet when it comes to investing, you’re not alone. Our education system is embarrassingly bad at teaching financial literacy; but that’s a rant for another day.
In reality, there isn’t much difference between real estate investing and the stock market. Here’s my “explain it to me like I’m eight” breakdown: if you own an entire company, just like an entire rental house, you are entitled to all of the profit it generates. If you and nineteen other friends go in together to buy an apartment building, your “share” would entitle you to 5% of the profits.
The same concept is true for stocks. The percentage of the shares you own in the company is the percentage of profits that you’re entitled to. You’ve likely heard of a “dividend,” which is simply the company distributing some of the profits they have earned to their shareholders.
The interesting (and confusing) thing about dividends is that even if the company is profitable, companies don’t always decide to pay them, which can actually be a good thing because you are also entitled to a percentage of the company’s value. Take for example the 5% share you own in our imaginary apartment building. Instead of taking the profits from the rent, you and the other owners could opt to reinvest that money into upgrading the shag carpet and wood paneling, which would increase the value of the building and, in turn, the value of your share. It would also bump up the rent, boosting your future profits.
You may have heard the term “growth” stocks, which are simply companies trying to expand rapidly, so they choose to reinvest their profits (if there are any) instead of paying dividends. For example, if you bought $1,000 worth of Amazon stock in 1997 and held it to this day, you wouldn’t have seen a penny of the profits the company has earned because they chose to reinvest them. Which brings me to the second way you earn money with stocks that most people are familiar with: appreciation. It might sound like a raw deal that Amazon hasn’t paid you any of your share in the profits, until you consider the fact that you could have sold those shares 23 years later for over $1,000,000. In real estate it’s what’s known as being “house poor.” Your property value (and wealth!) may be soaring, but it’s difficult to access that value until you sell.
The other term you may have heard thrown around in the investing world is “value” stocks. These companies are the opposite of growth stocks and pass along a large portion of their profits to shareholders as dividends. For example, at the time I’m writing this, Ford Motor Company has been giving shareholders about 6% of their share value a year in dividends. In other words, if you owned $100 of Ford stock, they would pay you $6 a year in dividends.
This is where I could really nerd out and give you a dissertation on value vs. growth, but I will spare you. The point isn’t whether you get cash from the profits now, in the form of a dividend, or later as appreciation in the value of the stock. The important thing is that one way or another those profits are yours to keep.
So while the stock market might not be quite as random as a casino, if you don’t look at it right, it can start to feel like the ups and downs of a drunken bender in Vegas. One problem is how readily available information is in today’s day in age. At the click of a button, you can open your investment account and watch the balances change like a roller coaster ride. On any given day there is only a slightly better than a coin flip chance that the stock market will go up; which means if you’re checking the balance of your account every day, you’re going to be disappointed almost half of the time.
The key is to look at returns over longer time periods so you can see the volatility start to level out. If you randomly picked any day during the last 50 years to invest a pile of money in the S&P 500 (the 500 largest US stocks) and waited 20 years, you wouldn’t have lost money once and would have had a good chance of averaging 8% annual returns*. This is where real estate investors can teach us a lesson. When you own a property you only have a vague idea of what it’s worth on any given day. If CNBC had a ticker tape of what that house was worth to the minute, it would cause a lot of heartburn and you’d likely see a lot more buying and selling in the real estate market, and in turn more ups and downs -- just like with stocks. Luckily that’s not the case, and as long as the rent checks keep coming in, landlords don’t really care what their property value is day to day, unless they are planning to sell soon.
Of course, this doesn’t mean 100% of your investments should be in the stock market, especially those of us who don’t have 20 years to wait for the bumpy periods to smooth out (which is where bonds come in, but that’s for another blog post). The moral of the story here is that the stock market isn’t a giant slot machine that you put your retirement dollars in and hope for the best. You’re actually buying small pieces of businesses that work around the clock so you don’t have to.
*Insert required “past results don’t guarantee future performance” disclaimer here.