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Author: LaughingLogic Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 5068  
Subject: Re: Something for me to think about Date: 8/10/2003 8:42 AM
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The big question is, does anyone who is smarter than I, all of you, think I'll make more money by buying some rental properties than I would if I stuck with stocks?

Yes. The key concepts regarding the benefits of diversification are non-correlated risks and, um, I don't know what it's called, but "non-additive compounding" would work.

First, your rental IRR will not be perfectly correlated with your stock portfolio IRR. Even were you to encounter the incredibly unlikely hypothetical extreme event of a renter using the exact same stocks you own to fund his rent, their prices cratering, and their dividends being cut, he would probably preferentially cut down on his discretionary spending before moving; and even if that wasn't enough, then you could (eventually) replace him with someone who has a job. In fact, I would expect rentals and stocks to be nearly inversely correlated, for two reasons. For one, most people pay their housing costs out of their wages -- if they don't own their residence outright, then it probably means that they can't afford to retire, since most people will eliminate the monthly cost if they can -- and business owners, employees, suppliers, and customers all compete for pieces of the potential revenue pie. For another, at this point in time, I think that stocks taken as a whole -- literally, such as a total market index fund -- are priced to a low enough dividend yield that they are clearly expected to depend more on price appreciation for their total return than a nice little rental would; so, your stock portfolio would probably take more of an IRR hit from price depression caused by rising interest rates (implying a shift in the time value of money) than your rental would.

Second, compounding is not additive. For example, $10,000 compounded at 10% for two years in a row is $12,100, but compounded at 0% one year and then 20% the next (or vice-versa) is only $12,000. Let's say that was the only difference in forty years, and for the next 38, they both compounded at 10% each year; just from that little $100 difference in the first two years, the first example would end up at about $452,593, while the second would end up at about $448,852. That's still not a huge percentage difference, but of course, there would actually be many more chances in 38 years for the more variable return to fall behind.

So, adding rental property (or, presumably, residential REITs) to your all-stock portfolio would be expected to smooth out your returns; and, all else being equal (and even sometimes when they're not), lower variance means faster compounding.

¤ Daniel ¤
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