Purchasing a Home: Is It Always a Good Investment?

Purchasing a home has long been considered a rite of passage and a solid investment, but the reality is that it is not always the case. While homeownership can provide a sense of stability and a place to call one’s own, it is vital to consider the various factors that can affect the value of a home and impact its return as an investment.

Home Buying Not Always A Good Investment

  1. Affordability: With the rising cost of homes and limited affordability, many people may need help saving up for a down payment and making monthly mortgage payments. As a result, they may find themselves in a difficult financial situation and need help keeping up with their payments.

  2. Location: A home’s location can significantly impact its value. For example, a home in a declining neighborhood may not appreciate in value over time, while a rapidly growing area may see substantial increases.

  3. Maintenance and repairs: Homeownership has many responsibilities, including maintenance and repairs. These expenses can add up over time and significantly impact the overall return on investment.

  4. Property taxes: Property taxes are expensive for homeowners and can be incredibly impactful in areas with high tax rates. This is something to remember when considering the long-term costs associated with homeownership.

  5. Economic conditions: Economic conditions, such as recessions, can significantly impact the housing market. This can result in declining home values and a decreased return on investment.

While homeownership can provide a sense of stability and a place to call one’s own, it is essential to carefully consider the various factors that can affect the value of a home and its return as an investment. Before deciding to purchase a home, one must consider one’s financial situation, the property’s location, and the overall economic conditions.

The Real Return

The average real return on owning a home is challenging to determine as it can vary greatly depending on several factors, such as location, property value, length of ownership, and interest rates. However, it is estimated that the average real return on homeownership is typically between 0-4%.

The Costs

This return considers the costs of purchasing a home, such as a down payment, closing costs, mortgage interest, and ongoing costs, such as property taxes, insurance, maintenance, and repairs. When these costs are factored in, the return on investment for homeownership can be much lower than many expect.

It is important to note that this is just an average, and the actual return on investment will vary depending on individual circumstances. Some people may see a higher return on investment if they purchase a home in an area with appreciating property values or if they own the property for an extended period. Others may see a lower return due to declining property values or unexpected expenses.

Robert Shiller

In his research, Robert Shiller has shown that over the long term, the rate of return on investment for homes is not significantly different from that of other investments, such as stocks or bonds. He has also shown that housing prices can be highly volatile and are subject to significant swings in value, which can impact the return on investment for homeowners.

Shiller is an economist and Nobel Prize winner known for researching the housing market and its impact on the overall economy. He has been critical of the notion that owning a home is always a good investment. Instead, he argued that it is much more complex than many people realize.

The Research

Shiller’s research has also shed light on the psychological factors that drive the housing market, such as the belief that homeownership symbolizes stability and success and that home prices will always appreciate value. He argues that these beliefs can lead to irrational exuberance in the housing market and contribute to bubbles, ultimately resulting in declining home values and negative returns on investment.

Overall, Shiller’s research has challenged the conventional wisdom that homeownership is always a good investment and has provided a more nuanced understanding of the complexities of the housing market and its impact on the economy.

Homeownership is a complex issue that requires careful consideration of various factors such as affordability, location, maintenance costs, property taxes, and economic conditions. The return on investment for homeownership may be lower than expected and can vary greatly depending on individual circumstances.

Disclaimer
The content on this site, provided by Able Wealth Management, is purely informational. While we aim for accuracy and completeness, we cannot guarantee the exactness of the information presented. The views and analyses expressed in this blog represent those of the authors at Able Wealth Management. They should not be considered as investment advice or endorsement of any particular financial instrument or strategy. Any references to specific securities and their performance are purely informational and should not be taken as advice to buy or sell.Before implementing any information or ideas presented, we strongly advise consulting with a financial advisor, accountant, or legal counsel. Investing carries inherent risks, including potential capital loss. Asset values can fluctuate over time and may be worth more or less than the original investment. Past performance does not guarantee future results, and Able Wealth Management cannot ensure that your financial goals will be achieved. Information from third-party sources has not been independently verified by Able Wealth Management. Although we trust these sources, we cannot assure their accuracy or completeness.

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Volatility Drag

Volatility drag, often unnoticed by many investors, plays a significant role in the performance of investment portfolios, especially in markets characterized by high volatility. Understanding volatility drag is crucial for making informed investment decisions and managing long-term investment performance.

Understanding Volatility Drag

Volatility drag refers to the negative effect of investment volatility on compound returns over time. It occurs because losses have a more significant impact on portfolio value than gains of the same magnitude. For example, if an investment loses 10% one year and gains 10% the next, the investment will not return to its starting value due to the mathematical asymmetry between gains and losses. This phenomenon underscores the importance of minimizing large fluctuations in investment value to protect long-term returns.

The Mathematics Behind Volatility Drag

The mathematical principle underlying volatility drag is relatively straightforward but profound in its implications for investors. The key concept is that percentage gains and losses are not symmetrical. A 50% loss requires a 100% gain to break even, not a 50% gain. This asymmetry means that volatility (up and down movements in price) can erode the compound growth rate of an investment, even if the arithmetic mean of the returns seems healthy.

Example of Volatility Drag

Consider an investment with the following annual returns: +20%, -15%, +10%, and -5%. While the arithmetic mean of these returns might suggest a modest positive performance, the compound annual growth rate (CAGR) would tell a different story, factoring in the volatility drag and showing a lower effective return than the arithmetic mean would suggest.

Implications for Investors

  • Risk Management: Understanding volatility drag emphasizes the importance of risk management strategies, such as diversification and the use of derivatives for hedging, to minimize significant downturns in portfolio value.
  • Investment Strategy: Investors might consider investment strategies that aim for steady, consistent returns over those with potentially higher but more volatile returns. Such strategies might include investing in low-volatility stocks, index funds, or using dollar-cost averaging to mitigate the impact of market fluctuations.
  • Psychological Aspects: Volatility drag also highlights the psychological challenge for investors who may overreact to short-term market movements. A long-term perspective is crucial for successful investing, as frequent trading in response to volatility can exacerbate the drag on returns.
  • Performance Evaluation: When assessing investment performance, considering both the arithmetic mean return and the compound annual growth rate (CAGR) can provide a more comprehensive view of an investment’s performance, factoring in the effect of volatility.

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