You’re a new investor attempting to diversify your portfolio, maximize your returns, and minimize risk.
As you explore your options, you are going to want to consider index funds and real estate — two investments that can diversify your holdings and increase your chances of earning positive returns.
So, which is the better option: Index funds or real estate? Here’s a primer to get you up to speed.
Index Funds: An Overview
Once you decide to enter the stock market, you’ll find there are two basic ways to invest. (There are other approaches and strategies that more seasoned investors can use, but we’ll save those for another post.) You can either purchase individual stocks, or you can invest in funds that give you access to a broad range of securities and equities.
That said, you don’t have to be exclusive — and many investors diversify their holdings by investing in both individual stocks and funds.
What Are Index Funds?
An index fund is a portfolio of bonds and stocks that tracks the performance of a market index — if the market overall does well, you do well, so you don’t have to pick and choose the winners. Examples of indexes include the Standard & Poor 500 (S&P 500), the Dow Jones Industrial Average (the Dow), and Nasdaq.
Index funds are typically passively invested, meaning they are automatically assembled and managed without human intervention. This makes index funds different from mutual funds, which are actively run by managers who attempt to beat market performance through various methods.
And just to be clear, having a fund actively managed is no guarantee of success — in fact, the majority of those underperform when fees are taken into consideration.
How to Invest in Index Funds
Index funds can be purchased through most brokerage accounts or from an index-fund provider like Vanguard or BlackRock. Unlike stocks, which are continuously traded throughout the day, index funds are bought and sold based on the price set at the end of the trading day.
There are two ways to invest in index funds.
Some investors choose to invest in index funds through brokerage accounts, which are set up for short-term and medium-term growth.
When you invest through a brokerage account, you have the freedom to liquidate at any time without facing a penalty from the Internal Revenue Service (IRS). However, you may have to pay fees to the broker where you purchased the index fund.
Index funds are excellent core portfolio holdings for long-term 401k investments, individual retirement accounts (IRAs), and Roth IRAs. Typically, index funds are more resilient to market swings, therefore they can provide more stability than individual stocks.
Retirement accounts can also provide tax protection for index funds, enabling investors to avoid paying taxes for decades. You’ll still have to pay taxes when retirement age rolls around, but this strategy can help maximize compound interest and grow your investments impressively over the long run.
Plus, if you’re retired, you likely will have less income and therefore will pay a lower tax rate.
The Pros of Index Funds
Passively managed funds tend to outperform actively managed funds over time. Active funds require direct human intervention, which means higher fees and doesn’t necessarily mean better returns.
Index funds can also provide steady, long-term growth for investors. Since they are diversified, index funds can protect investors from steep losses on specific stocks. If one or two accounts in a portfolio tank, they are going to be naturally worked out of an index — meaning it’s only going to lead to a temporary loss in the fund.
Because of their consistency and ability to produce large gains slowly over time, index funds are an excellent option for long-term “set it and forget it” portfolios.
Index funds have much lower fees than non-index funds. And, since index funds don’t require portfolio managers, they tend to have lower expense ratios. When it comes to expense ratios, the lower the better.
An expense ratio refers to the amount of the fund that goes toward growing your investment, as opposed to paying for management and administration of the funds.
The Cons of Index Funds
One of the downsides to investing in index funds is they often have a higher barrier of entry than individual stocks. For example, the Vanguard Dividend Growth Fund (VDIGX) comes with a minimum investment of $3,000, potentially putting this fund out of reach for investors who are operating on a budget.
That said, brokers like Vanguard typically offer index funds that don’t require minimum investments, too. For example, the Vanguard 500 ETF (VOO) has an expense ratio of just 0.03% and no minimum investment requirement.
Shop around to find the best index funds that align with your budgetary restrictions. Vanguard and Blackrock are optimal places to start your search.
Potentially High Fees
Watch out for index funds that have exorbitant expense ratios of 1.5% or higher. There’s really no reason for an index fund with high fees. And every dollar that goes into someone else’s pocket is a dollar that’s not building long-term wealth for you.
In addition, index funds can come with additional fees like annual charges and exit fees which occur when you trade or liquidate your funds. Always read a fund’s prospectus before purchasing it so that you have a clear understanding of what you’re getting involved with before you agree to anything.
Index funds have less flexibility than managed funds because they follow strategies to stay aligned with various indexes.
This can become an issue for a declining index. When this happens, fund managers have little choice but to ride out the dip and wait for the fund to turn around. A rebound almost always occurs, but it can take time to occur.
When investing in index funds, investors need to be patient. Otherwise, it can be frustrating watching a fund underperform for an extended period of time. The best strategy with index funds is to set it and forget it. Focus on diversifying your portfolio and looking for ways to offset downturns.
Don’t expect to get rich overnight with index funds. Even if you invest in a high growth index fund, your money will be spread out over an array of companies. So if one of the companies in the index happens to double in value in a short period, the success will be diluted since it’s only a small part of the fund.
The bottom line here is that index funds are an excellent option for slow and steady investing who are looking to grow their net worth over years and decades.
Now that you have a better understanding of how index funds work, let’s take a deep dive into real estate.
Real Estate: An Overview
What is Real Estate?
Simply put, real estate is a piece of land or property with buildings or permanent structures attached to it.
Real estate investing can be an outstanding strategy to grow your net worth. As with any investment, there’s also risk involved, which you can mitigate by being savvy.
How to Invest in Real Estate
Option I: Buy Property
Buying real estate can be as simple as purchasing a plot of land with a house, building, living space, or commercial area built on it.
You may also choose to only buy the living space within a building, such as an apartment space or condo. You can also purchase a business unit in an office building or retail environment.
Buying property typically requires finding a trusted real estate agent and working with financial lenders to get approved for a mortgage.
There are four types of properties you can buy.
A Home (Primary Residence)
The most common option is to buy a house, or primary residence, for you and your family. When you buy a home, you typically do so with the intention of owning it for an extended period of time, either as a primary or secondary dwelling place.
Buying a home can be one of the best long-term investments you make, as you move away from paying rent every month and instead pay a mortgage, which goes to your own equity in the home. However, it’s probably not going to bring in money quickly. And now you’re responsible for additional costs such as monthly maintenance expenses (e.g., lawn care, utilities) and unforeseen expenses (e.g., your refrigerator breaks or your water pipes burst).
What’s more, the only way to make money on your house is to sell it at an opportune time, when the market is favorable, and for more money than you bought it for. There’s certainly no guarantee that’s going to happen.
A more lucrative (but more risky) option is to buy a property with the sole intention of making money from it. In other words, this won’t be a place you live in. The aim is to look at it purely from a financial perspective.
One way to make money from an investment property is to flip a house, apartment, or series of apartments. House flipping involves purchasing a piece of real estate, fixing it up, and selling it for a profit. If you find a good deal and make the right improvements, you can potentially make a healthy profit.
However, house flipping is not for everyone. You have to be knowledgeable about home improvement and willing to do hard work. Renovating floors, installing windows, and painting houses, for example, are not easy jobs and they can take a lot of time.
Let’s say you have a full-time job and a family. It could easily take several months, or potentially over a year, to budget enough time to complete a bunch of repairs yourself. If you don’t have that time or the desire to do the work yourself, you will then need to have a network of advisors and workers who can do the jobs for you, ideally for a fair price. Manging those contractors is not an easy task, either. If you aren’t careful, it’s very easy to lose money on an investment property.
Another way to make money is to purchase a rental property that generates rental income. A rental property is residential real estate that you rent out on a short-term, medium-term, or long-term basis.
For example, you can buy a residential unit in a town or city with heavy tourism and earn cash from vacationers looking for short-term rentals on sites like Airbnb or VRBO. Most Airbnbs are rentable for a night, weekend, or even for several weeks or months.
This can be one of the most lucrative types of real estate investments because you can capitalize on seasonal surge pricing to maximize revenue. Keep in mind that a key to maximizing short-term rental investments is having an efficient, low-cost process for cleaning the unit and turning it over after each guest leaves.
It could also make sense to purchase a long-term residential unit and allow renters to lease your space on a monthly or annual basis.
Regardless of which option you take, if you don’t plan to be hands-on with your property when it comes to collecting rent or fixing and cleaning the unit, then it’s a good idea to hire a property management company to oversee operations. A management company can be expensive for real estate investors, but it provides a buffer between you and the tenants — preventing you from having to get directly involved with things like repairs and complaints.
Commercial Real Estate
Commercial real estate is a property that is purchased exclusively for business purposes. Examples include storefronts and office spaces.
Investing in commercial real estate can be risky, just like any type of real estate acquisition. However, it can also be a great way to diversify your portfolio and bring in a stable cash flow. If you get a good deal on a space in a desirable area, commercial real estate can be highly lucrative.
In the past, you had to be licensed and accredited to purchase commercial real estate. However, in recent years it’s become much easier for regular investors to enter the commercial real estate market (more on this below).
Industrial Real Estate
Industrial real estate is a subset of commercial real estate. It’s called industrial because involves buildings and land suited for industrial purposes, such as manufacturing, truck terminals, assembly, or Amazon distribution and data centers, to name just a few examples.
Industrial real estate can also be a lucrative way to diversify your portfolio. It can provide long-term cash flow, and usually comes with lower maintenance costs than traditional residential or commercial spaces.
You can invest in industrial real estate directly or through a crowdfunding platform like Fundrise, which I’ll explain shortly.
Option II: Buy Funds
As you can see, buying real estate requires resources in the form of time, a lot of money, and personal connections (like real estate agents, financial professionals, tenants, and home repair professionals). Not all investors have the resources in place to profit from buying a residential or commercial property outright.
Another option is to invest in real estate financial products.
Real Estate Investment Trusts (REITs)
One way to invest in real estate is to put your money into real estate investment trusts (REITs), using a third-party brokerage firm.
A REIT is a company that owns or finances real estate for the purpose of generating revenue. This model works like a mutual fund, where multiple investors pool their money together into a single account. The fund then generates dividends from real estate investments.
REITs can provide a steady income stream while letting investors profit from properties they would otherwise be unable to access or afford. At the same time, it can eliminate the nitty-gritty of owning property — like dealing with tenants, making upgrades, and buying homeowners or renters insurance.
A new type of investing that has emerged in recent years is called crowdfunding, which involves using technology and apps to connect investors with real estate opportunities.
For example, Fundrise offers a network of high-quality assets like debt-equity, commercial, and residential properties. The company’s strategy is value investing, which means acquiring assets for less than their intrinsic value. Then, Fundrise works to increase the value of its assets over time through management and partnerships with local operators.
Crowdfunding can be more expensive than using REITs because it can come with additional management fees and expenses. However, investors benefit from immediate diversification. Also, crowdfunding providers typically offer user-friendly dashboards that provide visibility into all of your investments.
The Pros of Investing in Real Estate
Investing in real estate can be a great way to diversify your portfolio. However, if your only real estate investment is your home, then your real estate investments are not diversified. As the wise Robert Kiyosaki, author of Rich Dad Poor Dad, once said: “Your house is not an asset. Rather it is a liability.”
Investing in a rental property, REIT, or crowdfunded investment portfolio can produce income on a passive basis — meaning you can earn money without having to do much.
If you’ve been reading my blog for a while, you should already know that passive income is one of the top hacks to building wealth. That’s because time is one of your most precious resources. Look for as many passive income opportunities as you can.
Check out my guide on how much you can make with real estate.
Investing in real estate can also provide some excellent tax advantages for investors.
For example, you can deduct some expenses on a rental property like property tax, property insurance, mortgage insurance, advertising expenses, and property repairs. This can lower your taxable income so that you pay less when tax season rolls around.
Further deductions can be made if you invest in real estate as an entity and treat it like a true business investment. Additionally, you can use home depreciation to your advantage.
The Cons of Investing in Real Estate
Real estate investing can carry some heavy risks for investors, such as:
- Vacancy: There’s no guarantee that a rental property is going to bring in renters, especially during down seasons. This can make it difficult to meet monthly mortgage payments.
- Damages: Investment properties are susceptible to risks like fires, floods, natural disasters, and irresponsible tenants.
- Bad investments: There is also the chance that a real estate investment can go belly-up, especially when investing in a low-demand real estate market area.
Unless you invest in a managed REIT or crowdfunded investment, or you pay a property management company to oversee operations, you can expect to put a considerable amount of resources into property and tenant management. This can be very stressful and time-consuming, making it hard for people with busy schedules.
Before entering into real estate, spend a few minutes thinking about your overall schedule and resources. Determine how much money and time you want to put in ahead of time.
For example, if you work full time and have limited funds to allocate toward property management, you may want to stick with a managed fund. On the other hand, if you have a lot of time on your hands, along with sufficient knowledge of homeownership and repairs, you have more freedom to act as a full-time landlord.
Taking on multiple mortgages can add a considerable amount of financial stress for an investor — especially if you use your current home as collateral.
In addition to making monthly mortgage payments, there are a variety of other expenses to consider. Downpayments on investment properties typically have to be 20% or more. Closing costs, monthly upkeep, property taxes, and insurance are just a few other expenses to consider.
Tips for Investors
Here are some other things to keep in mind as you continue along your personal finance journey.
Get Rich Slowly
Famous investor Warren Buffett recommends getting rich slowly by learning about finance, avoiding bad investments, and regularly investing a portion of your income each paycheck.
By following this investment strategy you can be conservative about investing and let time do the trick.
Don’t Forget to Save
Young investors who are gung-ho about entering into the stock market or real estate market often neglect to put money into savings accounts. This is because interest rates can be very low for certain accounts, making them unattractive.
Keep in mind that high yield savings accounts (HYSAs) can offer interest rates that are 20 times the market average. This can let you earn money in interest while keeping your money in an FDIC insured account.
Use a Financial Advisor
If you don’t know what you are doing, and you don’t have the time to do the research, it might not be a bad idea to hire a financial advising service. A sound financial advisor can educate you about your available options and help you navigate the complexities of investing and managing money.
Index funds are also great for beginners who lack the experience to pick individual stocks —and you don’t need a financial advisor to tell you that. Putting your money into index funds can give you broad market exposure, helping you profit without having to manage your account on a daily basis.
Frequently Asked Questions
Is real estate a good option for beginners?
It depends. Purchasing property can be like taking on a full-time job, which is very hard if you’re already working full-time and on a limited budget.
If you have cold feet about entering into the real estate market, consider investing in a REIT or crowdfunding platform. This can be a much more cost-effective strategy that comes with a lower barrier to entry.
Should I invest in real estate and index funds at the same time?
Sure. Investing in real estate and index funds is a smart way to mix up your portfolio. You can even consider investing in real estate index funds, which can offer the best of both worlds.
Only you or your financial advisor can determine where you park your money. Educate yourself on your options, scour the market for the best deals, and try to get some guidance from the best experts you can find.
What are ETFs?
Exchange-traded funds (ETFs) are similar to index funds because they deal with baskets of securities instead of individual funds. However, ETFs are bought and sold throughout the day while index funds are bought and sold based on the price at the end of the trading day.
What is Risk Tolerance?
Risk tolerance is an investor’s ability to withstand losing money on a particular investment.
Risk tolerance is typically based on your age, income, and financial goals. For example, a young investor that has several decades to invest can afford to be more aggressive about where they allocate money. Young investors may choose to allocate more money into equities like stocks, which are more volatile.
On the other hand, older investors typically have less of an ability to absorb risks, so they might want to focus on more stable assets like bonds, for example. You definitely don’t want to put your nest egg on the line with a risky stock or investment strategy right when you’re going to need it.
What is an asset class?
An asset class is a group of investments with similar characteristics, making them bound by common regulations. Assets may be stocks or equities, bonds or fixed income, or cash equivalent accounts like money market accounts.
Are property managers necessary for real estate?
It largely depends on how much time and money you have. If you are a very busy person who owns a home, works full time, and has a family, taking on a second property can be very difficult. It can require a lot of time and effort and can add a significant financial burden.
If you have limited time or don’t live near your real estate investment, you may want to use a property management company to handle tasks like finding tenants, cleaning up after them, and performing the upkeep.
However, if you enjoy the hands-on work of being a landlord, and don’t mind handling repairs and maintenance yourself, you probably don’t need to hire a property manager.
Are individual stocks better than index funds?
Index funds provide slow, steady growth while individual stocks are much less predictable in nature. Invest in stocks if you are in a position to absorb risk and unafraid to lose money quickly. Stocks can help you generate explosive gains, but they can also make you lose money at the same rate if you sell them in a panic. Don’t do that.
The best investors often have their funds in both stocks and index funds, and they definitely aren’t afraid to ride out market volatility.
The Bottom Line: Index Funds or Real Estate?
It’s not a matter of looking at whether one type of investment is better than the other. Both real estate and index funds can both provide steady, long-term gains, making them ideal for investors who have decades to grow their net worth.
Real estate and index funds both have a wide range of investment options and some can produce better returns than others. For example, a REIT can be a lower risk option than buying a house outright. But you can’t live in a REIT, either.
As an investor, you should explore the market to find solutions that align with your personal and financial goals. Also, the sooner you can get your feet wet, the more time you will have to maximize your investments. Oftentimes, people start too late in life after their prime earning years have gone by.
Never stop learning and don’t be afraid to take the plunge. Soon enough you will be on your way to financial freedom.