Here’s How Investing, Housing, and Speculating Intersect
We all know there was a lot of speculation going on in the housing market from 2005 to 2007 as risk-loving adventurists loaded up on NINJA (No Income, No Job, and No Assets) loans and subprime CDS (Credit Default Swap) securities. But there is a different kind of speculation going on now, and it isn’t tied directly to housing. Instead of buying a house with no downpayment and a no-interest loan, speculators are leaping into other hazardous areas of danger. Like a frog jumping from lily pad to lily pad, speculators are now hopping around onto money-chasing industries, including biotech, social media, Bitcoin, and alternative energy.
As French novelist Jean-Baptise Alphonse Karr noted, “The more things change, the more they stay the same.” Irrespective of the painful consequences of the bubble-bursting aftermaths, human behavior and psychology addictively succumb to the ever-seductive emotion of greed. Over the past 15 years, massive fortunes have been gained and lost while chasing frothy financial dreams in areas like technology, housing, and gold.
Most get-rich-quick dream chasers have no idea of how to invest in or value a stock, but they sure know a good story when they hear one. Chasing top-performing stocks is lot like jumping off a bridge — anyone can do it, and it feels exhilarating until you hit the ground. However, there is a better way to create wealth. Despite rampant speculation, most individuals understand the principles behind buying a house, which if applied to stocks, can make you a superior investor and assist you in avoiding dangerous, speculative investments.
Here are some valuable housing insights to improve your stock buying.
1. Price is the almighty variable
Successful real estate investors don’t make their fortunes by chasing properties that double or triple in value. Buying a rusty tool shed for $1 million makes about as much sense as Facebook paying $19 billion (1,000 times the estimated 2013 annual revenues) for a money-losing company, WhatsApp. Better to buy real estate when there is blood in the street. Like the stock market, housing is cyclical.
Many traders believe that price patterns are more important than the actual price. If squiggly, technical price moving averages (see Technical Analysis article) make so much money for stock-renting speculators, then how come day traders haven’t used their same crossing-lines and Point & Figure software in the housing market? Yes, it’s true that the real estate transaction costs and illiquidity can be costly for real estate buyers, but 6 percent load fees, lockup periods, 20 percent hedge fund fees, and 9 percent margin rates haven’t stopped stock speculators either.
2. Cash is king
It doesn’t take a genius to purchase a rental property — I know because practically half the people I know in Southern California own rental properties. For example, if I buy a rental property for $1 million cash, is it a good purchase? Well, it depends on how much after-tax cash I can collect by renting it out.
If I can only net $3,000 per month (3.6 percent annualized return) and be responsible for replacing roofs, fixing toilets, and evicting tenants, then perhaps I would be better off by collecting 6.5 percent from a low-cost, tax-efficient exchange-traded real estate fund without having to suffer from all the headaches that physical real estate investing brings. Forecasting future asset price appreciation is tougher, but the point is, understanding the underlying cash flow dynamics of a company is just as important as it is for housing purchases.
3. Debt/leverage cuts in both directions
Adding debt (or leverage) to a housing or stock investment can be fantastic if prices go up and disastrous if prices go down. Putting a 20 percent downpayment on a $1 million house works out wonderfully if the price of the house increases to $1.2 million. My $200,000 downpayment is now worth $400,000, or up +100 percent. The same math works in reverse. If the price of the home drops to $800,000, then my $200,000 downpayment is now worth $0, or down -100 percent (ouch). Margin debt on an equity brokerage account works in a similar fashion, but usually a 50 percent downpayment is needed (less risky than real estate). That’s why I always chuckle when many real estate investors tell me they steer clear of stocks because they are “too risky.”
4. Growth matters
If you buy a home for $1 million, is it likely to be worth more if you add a kitchen, tennis court, swimming pool, third floor, and putting green? In short, the answer is yes. The same principle applies to stocks. All else equal, if a company based in Los Angeles establishes new offices in New York, London, Beijing, and Rio de Janeiro, and then acquires a profitable competitor at a discounted price, chances are the company will be much more valuable after the additions. The key concept here is that asset values are not static. Asset valuations are impacted in both directions, whether we are talking about positive growth opportunities or negative disruptions.
Overall, speculatively chasing performance is tempting, but if you don’t want your financial foundation to crumble, then build your successful investment future by sticking to the fundamentals and financial basics.
Wade Slome CFA CFP is president and founder of Sidoxia Capital Management and shares his investing insights at Investing Caffeine.