Where should I invest?

Should I invest:

• In a bank account?
• In a home?
• In stocks?

This question has no simple answer, but it has an answer. Moreover, it is possible to simplify the key elements of that answer. This post is about explaining how different investments can be compared. A word of caution. It is said that a little knowledge is a dangerous thing. It is not the “knowledge” that is dangerous. When a little knowledge brings with it a great deal of “confidence”, that overconfidence can cause a person to take outsized risks and ultimately bring misfortune. Bear in mind that what I say here is a deliberately simplified answer to a difficult question.

Let’s start with the bank account, as this is the simplest investment. Let’s say you put $100 into a savings account in a bank, and the bank pays a 2% interest rate. The $100 is called your principal, and the $2 you will earn in a year is the return on your principal. The chance that you will lose your principal ($100) is small. It can happen, e.g. if the bank shuts down and your account is not backed by the government, but this happens rarely. In the United States, the FDIC protects investors against loss of deposits from bank failure to a significant extent.

How does the bank account above compare with a home? Just as we can put $100 into a bank and earn interest, we can similarly buy a home and earn rent. A two-bedroom, one-bathroom apartment in San Francisco could cost $1 million to buy and $40,000 a year to rent. The rent-to-price ratio is therefore $40,000/$1,000,000 = 4%. If I had a million dollars in cash, I could buy such an apartment and earn a 4% return in the form of rent. This basic idea is simple. Now, let’s get into the weeds. Unlike a bank account, where the principal is fixed, the value of a home can change. Home values usually increase over time, but sometimes they fall like they did when the US housing bubble burst. There are maintenance costs and a variety of taxes (and some tax benefits) associated with homes. Homes are also illiquid, meaning it is not always easy to buy or sell a home.

How about stocks? A stock or a share represents partial ownership of a company. If a company has one million shares, and each share is worth $10, then the company is worth $10 million, which is called the company’s market capitalization. If this company earns $1 million in a year, then the earnings per share is $1 million / 1 million shares = $1/share. The ratio of earnings to price is called the earnings yield. In this case, it is $1/$10 = 10%. Stocks carry many risks, including the risk of going down to zero, and prices that fluctuate daily. Besides, even though the share in this example has an earnings yield of 10%, that 10% is not paid back to the shareholder. Some part of it (or none of it) may be paid out in the form of a dividend to the shareholder. In the example above, if the company chooses to pay 20% of its earnings (20 cents per share) to shareholders, then it has a dividend yield of just 2%. Some investors attach more importance to the dividend yield, which is what they are being paid “now”, than the earnings yield which is reinvested in the company. This example is over-simplified, but it illustrates the idea that money earns return when invested in a business.

The annual interest rate in a bank account, the rent-to-price ratio of a home, and the earnings yield of a share represent the same idea for different investments – the idea of return on investment.

Going back to what I said about a little knowledge, it would be dangerous if the message you take away is that one can compare a bank account, a home and a share of a company based on their return on investment alone. The risks are totally different, so such a comparison would not be apples-to-apples. That said, I find it helpful to compare investments using their long-term expected return, which is what one might reasonably expect if holding the investment for many years. This isn’t easy to calculate, but great minds (including some Nobel laureates) have worked on it, so it’s at least partially understood. I’ll talk more about this idea in later posts.