Thomas Veatch on Real Estate

Investment Strategy

Everyone wants to know how to invest to make the most money. Here's my view, which puts two and two together to make money.

One: How to bet

In the branch of mathematics and electrical engineering known as Information Theory, there is a theorem on betting on horse races. The theorem concerns how to bet in order to have the fastest expected rate of return. The theorem says that when betting on (a portfolio of) horses in a horse race, you should NOT bet your money on the horse that is most likely to win -- because SOMETIMES that horse will lose, and then you have lost everything.

Instead the way to obtain the optimal doubling rate (the highest rate of return), is to bet on ALL of the horses, each in proportion to its probability of winning. This theorem generalizes to the case of stock markets, where there are many degrees of winning, not just one, and many winners, not just one. Therefore, to make the most return, one should invest in all the assets, each in proportion to its probability of winning -- that is, of its being a good investment, or in other words, giving the greatest return on the investment.

Two: How to know how to bet

Okay, suppose I agree that I should bet on all, each in proportion to their probability of success. But that leaves the key question unanswered: How do I get a good estimate of that probability for each asset in the market?

The answer is, this is an information game, and the price is all the information you need. In an information game, what you know tells you how to invest your money. And the information, according to some, is the price of the asset. Let me tell you a story, which might make you agree with this.

One week I was visiting a small company in Connecticut for a few days. On Wednesday I went to lunch with the CEO and the CTO, and before we went to lunch, we checked the stock price, and it was about a dollar fifty. They were so proud, See, how the pink sheets work? We're worth a dollar fifty! After lunch we came back and happened to check again, and suddenly it was about two fifty. An enormous, amazing increase. The CTO says to the CEO, What happened, do you know what happened? The CEO says to the CTO, I have no idea! Both of them looked at me, as if I might know something. Nope.

Then on Friday, a couple of days later, the company got a huge order from AT&T, which was a really significant event for them. It validated their technology, and gave them survival money for a while. THAT was the reason. So from this I conclude that you can be the insider-est of all insiders, the CEO and CTO of a company, and have no idea what is going on with the value of your stock. But at the same time, the price of the stock knows.

How? I'll tell you how.

The people that have the real information use their information to buy it up, until the price rises so much that the driving information doesn't justify any more increase in the price. The information is in the price, and it is there faster and more accurately than anyone legally ought to be able to determine.

This is called the Informational Theory of Pricing: Everything that anyone needs to know about an asset is encoded in its price. If you want to know how good an investment any asset is, just look at its price, its total value as a whole asset -- if it is a company, it's called its market capitalization.

The price of an asset on an open market is a super-efficient, highly sensitive indicator of all the information that everyone knows, weighted by the confidence they each have in their particular perspective.
You can't do better even if you are the CTO or the CEO of a company and have the inside information that my friends had when they still had no idea why their stock went up by 65%. The price contains everything, and you cannot hope to beat it. So that's the Informational Theory of Pricing.

Answer: Indexing

Here we have the answer to the first question, the probabilities we need to figure out in order to bet proportionately on everything. Bet in proportion to the total value of each of the assets. So if the market capitalization of Google is double the value of Microsoft, then for every dollar you put into Microsoft, you should put two dollars into Google. That's how you should bet your money, according to Information Theory and the Informational Theory of Pricing.

And as it turns out that this is just a fancy new way of arguing for an old idea called Indexing. An index fund buys up all the assets in its list, putting proportionately more into the larger assets. That's the investment approach that most academics support, and that is on average the approach to beat, which on average beats the returns of actively managed mutual funds and investment managers.

So in short you should index everything. Wherever money is, in whatever assets money can flow into and out of, you should buy a piece of each asset or type of asset, in proportion to each one's total value.

What about real estate?

Now have I said anything that restricts this argument only to stocks? No. I have been talking about any assets that money can buy and owners can sell.

So what about Real Estate assets? Stock market and investment analysts generally say little or nothing about Real Estate assets. The most you can get nowadays is some comment that people should increase their real estate portfolio exposure from 5 percent to maybe 12 percent, when the stock market is down and the real estate market is booming. You will see in a moment why this is such a dumb, pathetic, watered down idea.

Notice that I wrote this in 2006 the middle of a great real estate boom, which was followed shortly in 2008 by a great real estate bust known as the Great Recession. So you are free to conclude that Dear Tom you are a crack head. That's fine, but very little I've said is limited to 2006, and indeed it shifts very neatly by the data of the day: what is today the relative value of the two types of asset. So go look up the relative value of all equity in stocks and all equity in real estate in the US, and you will have your up to date ratio.
So, What is the actual value of stocks versus real estate? The data I found, in 2004, says that the total value of US ownership interests, whether the underlying assets are stocks or real estate, is 52% in stocks and 48% in real estate. These numbers are a little messy because some stocks are for REITs and have other real estate components in them. Which shifts it in the direction of real estate. But for a first glance, this looks essentially like about a one-to-one ratio of real estate to stocks.

So this means if you have two investment dollars, you should be putting one into stocks, fine, but the other you should put into real estate. That's about the right way to appropriately index between stocks and real estate. So far, so good, and already, so revolutionary. But...

What about real estate with leverage

But think about leverage here. If you are a normal person, you don't leverage your stock market investments. You buy a dollar of stocks with a dollar of money. Do you go down to the bank on the way to the stock market and borrow four dollars to match every one you're about to put down on IBM stock? Heck no! A normal person doesn't get all crazy with risk by buying options or doing hedging or otherwise leveraging your cash for a better stock market return. Because the stock market is pretty darned risky, and goes down often and far. There have been sixty year periods in the stock market with no inflation-adjusted increase in value (look starting 1870s or 1880s to 1930 or 1940). It's not all that safe an investment.

Whereas if you put down a dollar to buy real estate, you absolutely do go to the bank on the way to the escrow office and get a loan for four dollars, and the asset you buy is worth five dollars, with 20% down and 80% mortgage. This is the normal way to buy real estate. In commercial real estate it's more like 40%-60%, but the point is the same. Shift WAAAAAYY over toward real estate. Real estate is so much safer than stocks that banks are willing to help you to leverage your purchase by two or four times the money you are putting down, for terms like 15 and 30 years. Imagine if banks would lend you four times your down payment to buy any random stock for a period of 30 years. Not imaginable. So you can see how amazing this difference is.

Conclusion

What this boils down to is this. If you have two investment dollars, you put one dollar into the stock market, and you put one plus four equals five dollars into the real estate market. And you will have a total of six dollars of ownership.

So what indexing tells you is not to increase your real estate exposure from 5 to 12 percent, but to go all the way the other direction, with 5/6 or around 83% of your assets in real estate. All these namby pamby small percentage investment suggestions are merely the work of a bunch of stock market analysts who make their money off of churning your money over and over through a lot of expensive and risky stock market transactions, whereas if you think about all the millionaires you know, how many of them have their money in real estate instead of in stocks. I bet it's most of them in real estate. There are a few lucky stock market winners out there, the whole technology business and the stock market world itself are all about making a few glory stories so the rest of us can pay interest to the busy little stockbrokers who are taking all our money. But people that invest in real estate are in a good situation. Time passes, time is their friend.

So this argument is that if you want to make money, you should be heavily slanted in the direction of real estate, far far more heavily than any stock market adviser will ever tell you. But if you follow the logic of Information Theory and the Informational Theory of Pricing, and the data of the actual value of real estate versus stocks, then you must conclude that it follows by theorem that most of your money should be in real estate, and that that is the true game of wealth in America, not the glitter game of stock picking.

So you might ought to move your money into real estate, unless you're already mostly all there already, which if you're rich, you probably are. That's what I'm doing, and that's what I would suggest you do too, if I were a qualified financial adviser. Since I'm not, you better figure it out your own self.

 

Copyright © 2006-2017, Thomas C. Veatch. All rights reserved.
Modified: April 12, 2006, December 3, 2017