Investment performance isn’t everything
What if I told you that investing at 7% can be more profitable than investing at 10%?
In this article about my best investment so far, we’ve seen that performance isn’t everything – liquidity matters just as much.
But today, I would like to focus on performance. Usually, the higher the performance, the more appealing the investment, right?
Wait… not so fast! You might say that there is also the issue of risk, and it would be true. If you would consider potential performance only, then playing the lottery would be the best investment in the world. Think about it: invest, say, 5 francs (I have no idea how much a lottery ticket costs) and earn 150 millions. Best investment ever! Except that the chances of you earning the jackpot are abysmally low.
So an investment at 3% guaranteed might be better than an investment at 5% with no guarantees.
But risk is not something I want to talk about today.
Today I want to talk about two investments with comparable level of risk. One at 7% (investment A) and one at 10% (investment B). And I want to demonstrate to you that the one at 7% is more attractive.
I should mention though that A and B differ by more than just performance.
- Investment A provides 7% compound interest and can be started with just a few hundred francs.
- Investment B provides 10% simple interest and requires a 200k minimal investment.
Any idea what investment A and B could be in real life?
You might have guessed already: investment A is buying shares of a diversified index fund and investment B is buying an apartment building in Switzerland.
Now, the assumption that buying an apartment building gives you a 10% net of everything on a real estate project in Switzerland is… a very generous assumption. I honestly don’t know how you would get there, because given the current prices, the best you can get at the moment is 5-6% gross rental yield, which translates into a maximum 15-18% return on cash invested, thanks to the leverage, before all expenses (interests, maintenance, taxes, etc.). But we are not going to be concerned about the actual performance of an apartment building in Switzerland. We are going to assume that the performance is 10% net on cash invested.
But let’s make it more real.
John and Sally
Imagine two successful professionals, John and Sally. They are both 25 and for the sake of this exercise, let’s say that they can both save and invest 40k per year.
John wants to invest in real estate. The kind of property he wants cost around 800k. He talked to his bank and they’re willing to give him a mortgage if he can bring 30% of the price in cash. That’s 240k or 6 years of savings. After 6 years, he finally buys the property and manages to get the awesome net yield on cash invested of 10%, or 24k per year.
Sally on the other hand decides to invest in the stock market and manages to get 7% per year (compounded). But since she’s able to get that yield from the start, after 6 years of saving, she owns a portfolio worth 286k. If she stops saving after that and just lets her portfolio grow on its own for 4 more years, she will own around 400k of stocks, while John will be at 336k (his original 240k plus 4 times 24k).
John earns a better return than Sally (10% vs. 7%) but since Sally has a 6 years lead and because her investment compounds, she outpaces John in the wealth accumulation race (FYI, that’s not actually a thing…).
Although the yields offered by real estate seem appealing, they only apply when you’re able to buy a property (that sounds painfully obvious but I’ve found no other way to say it). All the years before the acquisition offer no yield at all and that’s a drag on the long-term performance.
You might argue that the two investments have two different levels of risk so my initial assumptions is wrong. And in the short term you are most definitely right. But in the long term (20+ years), I would argue that a diversified index fund is actually less risky than a single apartment building.
There is also the issue of predictability: rental yield and income are easy to plan for while the stock market performances can be quite erratic.
So I’m not saying that no one should ever invest in Swiss real estate. If that’s your thing, more power to you! (Make sure you read this article about the good, the bad and the ugly of Swiss mortgages though…)
I’m just saying that better performances isn’t the right reason to do it. Even if the yield might appear higher, it usually isn’t due to the minimum investment hurdle and the lack of compounding.