It's Holding Americans Back

Despite five years of impressive returns from the stock market of some 120 percent – an average of 24 percent each year – many Americans seem very disinterested in stocks, if not apprehensive about them.

A new survey by Princeton Survey Research Associates International polling 1,010 Americans aged 18 and over found that despite dismal interest rates on cash accounts and certificates of deposit, 73 percent of respondents were not inclined to invest in stocks.

The first explanation that pops into mind is that people are still shell-shocked by the 2008 market correction, and that their finances have worsened to the point where they couldn’t invest even if they wanted to.

But that’s not the case at all.

When asked if their overall financial situation had improved or deteriorated over the past year, 45 percent answered their situation remains about the same, while 29 percent indicated conditions had actually improved for them.

So what is holding most Americans back from investing in equities? Could the low participation rate in stock investing be behind the nation’s growing wealth inequality, making the rich richer and the poor poorer? Could the stock market be the opportunity that turns your financial circumstances around?

Familiarity is Critical

One reason so many are still not invested in equities despite such a stellar bull run is that they are simply unaware.

Sure, increased time spent on the Internet is exposing people to more banner adds offering to help you get rich trading penny stocks. But a study by the Social Science Research Network found that while “the Internet indeed has a positive and causal effect on stock market participation… the positive effect of Internet usage on stock market participation” affects mainly those “households with a high degree of financial literacy”.

In other words, simple exposure to stock investing opportunities via the Internet or on TV isn’t enough to draw in the masses. Familiarity with investing and prior investment knowledge are required.

It is well understood that people tend to remain within their comfort zone. Where we live, the careers we choose, the foods we eat, and even the financial instruments we invest in – are all primarily selected based on what is familiar to us. It takes an adventurous spirit to break through such comfort boundaries into new grounds.

Of course, many will experiment on some things from time to time, expanding their horizons and acquiring new tastes. But rarely when it comes to investing. That’s one area where adventurism hits a brick wall.

Conservatism Versus Adventurism

When it comes to adventurism, expressions like “curiosity killed the cat” and “fools venture where wise men dare not” do have some validity. Lack of familiarity can lead you into serious trouble when dabbling in something new. Even “a little knowledge is a dangerous thing”, as another expression aptly puts it.

But when we compare the long term returns of various investments, figures show that being overly conservative can be just as dangerous when we count all the missed opportunities. This is clearly evident in the graph below comparing the performance of stocks, bonds, gold and cash from 1802 to 1997. (Keep in mind, of course, that this is before the huge run up in gold and equities of the past dozen or so years.)

Source: WordPress.com

As depicted above, returns are generally related to risk, where stocks produce higher returns than bonds and cash. (Let’s omit gold from this comparison, since its decoupling from the dollar in the early 1970’s has transformed it from an ultra conservative investment to a rather risky one.)

Interestingly, these figures factor in inflation, as can be seen by the dollar losing 90 percent of its value over that period of time, making stock market returns all the more impressive.

If Americans are still not investing in stocks after so much proof – both recent and historical – it is because they are simply unaware. It is quite the disservice to future adults that investing is not taught in high school, for investment knowledge would serve people much more than learning about the French Revolution or how many stomachs a cow has.

Parents aught to take the initiative to educate their children on at least the basics of investing. That is, of course, after the parents have acquired more knowledge themselves. It is this “financial literacy” that is in large part responsible for the income and wealth disparities that exist today.

There is one major investment category not represented in the comparison above, one which is probably the most widely accepted investment choice for most Americans – real estate. Yet even here the adage rings true that a “little knowledge can be dangerous”.

Real Estate Investing – Conditions Apply

There are many who will swear by it: “Owning a home is the best investment you could ever make.” And to some extent they are correct; depending on one’s circumstances, that is. In some cases, owning a property – especially a second property or more – could be more harmful than helpful.

When research and management consulting company Gallup Inc. asked Americans to choose the “best long term investment”, real estate was by far the favorite choice.

Yet according to one calculation using housing data compiled by Robert Shiller, the 2013 winner of the Nobel prize in economics, housing prices over the past 100 years have grown at a compounded annual rate of just 0.3 percent after adjusting for inflation. Meanwhile, the S&P 500 stock index has increased by an annual rate of about 6.5 percent over the same period – despite having endured so many more corrections and crashes than real estate has.

So why do so many Americans favor homes over stocks? Again it comes down to familiarity… there really isn’t anything very complicated about home ownership. Property is more tangible than equities, and our lives are more intimately connected with homes than with stocks from our birth. People know homes a lot more than they do stocks.

Then there is the frequency of stock market crashes over real estate crashes. As severe as the last property bubble’s burst may have been, it was only the second in 90 years going back to the Great Depression. How many crashes has the stock market suffered in all that time, a couple dozen perhaps?

We can see, then, why most would view real estate as the better investment option.

Shiller adds yet another reason people tend to choose homes over stocks… the lingering memory of the price paid. “People remember home prices from long ago better than they remember other prices,” Shiller explains. “Ask anybody, ‘What did you pay for your home?,’ and they’ll remember even if it was 50 years ago. It will be some ridiculous number like $30,000. They then compare it to today’s prices, and it makes a big impression, and they forget there has been so much inflation since then.”

Yet the price of a stock is rarely remembered, and its appreciation is rarely compared. Such as Apple stock rising from $10 to $524 in 12 years, or Warren Buffet’s Berkshire Hathaway stock rising from $20 in 1967 to over $190,000 today!

Even while renting an apartment, investing in stocks can be better than owning a home, despite losing a hefty sum in rent. If your rent is, say, $800 a month, and you are investing another $800 a month in stocks, your rent would effectively be tossed out the window, leaving only $800 per month in stocks to generate 6.5 percent annual inflation-adjusted returns over time. At the end of 30 years, you would have a stock portfolio worth some $883,000.

Yet if you purchase a $250,000 home and put your combined $1,600 per month onto your mortgage, at the end of 30 years you would be left with a home worth around $272,000 (if Shiller’s 0.3 percent annual inflation-adjusted appreciation rate is used), or around $440,000 (if we simply add 2 percent inflation per year).

The comparison? Your stock portfolio would be worth more than twice what your home would be worth.

Returns are Relative to Risk

But again we must remind ourselves that a little knowledge is a dangerous thing. If we are not confident in our investment skills or if we simply have no desire to expand our “financial literacy”, then buying a home would be the safer way to go.

Just remember the 3-Rs of financial schooling – Returns are Relative to Risk. Low risk will generate low returnsover longer time horizons. Greater investment knowledge will enable you to handle more risk and generate higher returns, and is undoubtedly one prominent factor contributing to the wealth gap between the investment literate rich and the investment illiterate poor.

Yet regardless of how much knowledge you may have, whether you lean toward conservatism or adventurism depends on what your stomach can handle, and what allows you to sleep at night. Nothing is worth loosing your health – whether physical, mental, emotional, or financial.

Joseph Cafariello