It’s the investor’s dilemma.

Should you invest in direct residential property, or put your money into a portfolio of shares? For many, it’s one or the other, not both.

Property

Many investors prefer residential property investment – and Australians have been led to believe that negative gearing is the greatest thing since sliced bread. It does have benefits for sure, but the negatives (excuse the pun) are often overlooked.

Negative gearing is where property investors can claim a deduction against their ordinary income for property investment expenses not covered by the rent. Things such as strata/body corporate fees, management fees, repairs, interest on the bank loan, council rates, insurance and land tax.

The problem with that strategy is that those losses each year mount up over time, and unless the property sees decent capital gains, investors can end up going backwards – even if they sell the property for a higher price than they bought it for.

Shares

Alternatively, investors could take out a margin loan and invest in shares, but there are several disadvantages of margin loans over investment property loans. Those factors include higher interest rates, lower lending levels, the potential for margin calls as shares get revalued each day unlike property, and for many investors, a step up in required knowledge and experience to invest in the right shares.

Investing without a margin loan usually means having a sizeable lump sum in the first place too.

Past performance

According to the recent ASX long-term investing report, residential investment property saw gross returns (before tax) of 9.8% per annum for the 20 years to December 2014, slightly ahead of Australian shares on 9.5%. However, if the investments were made through super, then Australian shares returned 9.9% after tax compared to 9% for residential property.

Some might argue too that as Australia hasn’t seen a recession in more than 24 years, the past 20 years of investment returns is not a true indicator of ‘real-world’ returns for any asset class.

However, there are very good reasons for property investors to consider diversifying beyond property. Many of us own or are in the process of buying the house we live in, so investing in property as well leaves us heavily exposed to a downturn in the property market.

There’s also the potential to beat the market’s return and drive much higher returns by investing in shares.

Rentvestors

Many first home buyers are opting to make their first home purchase an investment property and either rent elsewhere or live at home with the parents. Dubbed ‘rentvestors’, around a third of investors in 2016 were first-home buyers who had not yet bought their own home, according to a survey by mortgage broker Mortgage Choice Limited (ASX: MOC).

2 years ago, around 20% of investors fell into this category according to Domain, showing how popular the strategy has become. (As an aside, the results are also likely skewing ABS data with no category for first home buyer investors.)

The case for shares

From the statistics above, it’s clear that particularly for SMSFs, shares are the better option. And for diversification purposes, investors should consider a share portfolio outside of super too.

We’ve outlined the 13 Steps to Financial Freedom here, including how to get started in shares, and you can find loads of articles on our website of how to set up a diversified portfolio – including this series.

Foolish takeaway

It doesn’t have to be a case of property or shares. Investors can have the best of both worlds with investments across both asset classes.

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Motley Fool writer/analyst Mike King doesn't own shares in any companies mentioned. You can follow Mike on Twitter @TMFKinga

The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.