How to make strategy for diversification between real estate and stocks?

Question

I am living in tier 2 city in India and my father have all investments in real estate in my city. He had brought land earlier(20-25 years ago) when the prices were pretty low. It has given so much returns and I calculated CAGR of investment in real estate and it ranges from 20-30% which is very huge. Due to this, he strongly believes that money should always be invested in real estate as he had lost the money in stocks because none of my family members have knowledge of stocks in deep and it was like gambling according to me. Due to this, he enforces me to invest only in real estate as it has given him huge returns. How should I plan my investment between real estate and stocks and what are pros and cons of it?

Also, another problem with his investment is that the return I have calculated on investment is purely due to increase in prices of lands. He has not rented any single piece(may be due to fear and various other risk factors). So, Can anyone give some idea that can that investment be considered as good or bad because it is increased in value but not giving any income unless we sell it. The main drawback of such investment(according to me) is that money is blocked in this investment and standard of living is not increased due to no income from that money. What are your views on such type of investment?

Sorry if this is not great question but I can't ask questions to people surrounding to me as most people are not aware about financial literacy and some give weird answers which does not give any sense at all.

Answer 1

Past returns are past, future returns are future.

I have no experience in Indian real estate market, but I should mention that any CAGR should take into account inflation. Stocks yield about 6% above inflation. If inflation has been on average at 14-24%, that explains the origin of the high CAGR in real estate.

Also, how much time has your father spent in acquiring, developing and selling real estate? You should take into account the value of that time in the calculated CAGR. Could be that if the value of the real estate is low, but the amount of time spent in managing the investment is high, that the origin of the CAGR is not inherent return in the asset class, but rather the time spent.

With stocks, it's very easy. Just buy an internationally diversified low-cost ETF portfolio. Few hours to find suitable ETFs and estimate the allocation between them.

Also, there's a risk vs return tradeoff. With higher risk, you get higher return. If you buy particularly risky real estate (such as real estate that has no buildings yet), you are essentially buying something akin to an option. If building prices go slightly down, your real estate with no building is worth nothing, because nobody wants to construct new buildings. The construction industry is heavily cyclical. So, I'm saying that the great CAGR could be partially based on the high risk of the investment. With lower risk, you get lower returns.

Furthermore, there's a reversion to the mean tendency in asset class returns. If some asset class has yielded a lot in the past, chances are it will yield less in the future. Prices are not some random process; they revert to the mean.

Diversification is your friend.

With real estate, it's practical to invest only locally. That exposes you to a terrible risk. If the Indian economy suffers, you will suffer. With stocks, you can (and should) invest not only in Indian stocks, but in US, European, Japanese, Australian, Canadian, etc. stocks.

If you after careful consideration have decided that owning a house is better than renting, buy a house where you live. That alone means you are already exposed to the real estate market. The rest of your investments should be diversified to a low-cost stock portfolio.

But I'm suggesting that the other option, renting instead of buying, can mean lower total risk (you are not exposed to the risk of an individual building) AND higher return (often times, stocks yield more than real estate).

For those who have a lot of money to invest, there may be a chance to invest to more real estate than the house where you live. If that is the case, of course some allocation between real estate and stocks has to be decided.

Stocks can be real estate, too, with good diversification.

There are stocks of companies that invest in real estate. Those tend to be diversified better than individual real estate purchases. I would heavily recommend such stocks to consider instead of direct investments to real estate. Of course, with such stocks, the management expenses will be deduced. For someone expert in real estate investing, it may make sense to use your own time to manage the investments. But for someone whose time is valuable or who has no expertise in real estate investing, it may make sense to have someone else do the management.

With a well diversified stock portfolio, you get real estate stocks too.

If you buy an index fund or index ETF, they already have some amount of real estate stocks. They have stocks in other sectors, too. Thus, I would encourage you to consider if the real estate that is already in a diversified stock portfolio is enough for you.

Also, another problem with his investment is that the return I have calculated on investment is purely due to increase in prices of lands.

Sounds like a particularly risky investment. Not only that, but also an investment that can yield a lot if the inflation is high. (Hint: stocks yield a lot too when inflation is high.)

A real estate whose value consists of only the value of land, not the value of any building on it, is very similar to an option. I would recommend to avoid investing into options or option-like assets.