Monday, March 03, 2008

Markets Work

Markets throughout the world have a history of rewarding investors for the capital they supply. Companies compete with each other for investment capital, and millions of investors compete with each other to find the most attractive returns. This competition quickly drives prices to fair value, ensuring that no investor can expect greater returns without bearing greater risk.

A Picture of Growth
Growth of $1

In US dollars. For the eighty years from 1926 to 2005, the compound annual growth rate of return was 11.77% for the Small Cap Index, 10.36% for the Large Cap Index, 5.50% for the Long-Term Government Bonds Index, 3.70% for T-Bills, and 3.05% for Inflation (CPI). Large Cap Index is the S&P 500 Index®; Long-Term Government Bonds Index is Twenty-Year US Government Bonds; T-Bills are One-Month US Treasury Bills; Inflation is the Consumer Price Index. Small Cap Index provided by the Center for Research in Security Prices (CRSP), University of Chicago. The S&P data are provided by Standard & Poor's Index Services Group. Bonds, T-Bills, and Inflation provided by © Stocks, Bonds, Bills and Inflation Yearbook™, Ibbotson Associates, Chicago (annually updated work of Roger G. Ibbotson and Rex A. Sinquefield). Indexes are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.
Traditional managers strive to beat the market by taking advantage of pricing "mistakes" and attempting to predict the future. Too often, this proves costly and futile. Predictions go awry and managers miss the strong returns that markets provide by holding the wrong stocks at the wrong time. Meanwhile, capital economies thrive—not because markets fail but because they succeed.
The futility of speculation is good news for the investor. It means that prices for public securities are fair and that persistent differences in average portfolio returns are explained by differences in average risk. It is certainly possible to outperform markets, but not without accepting increased risk.


domus said...

Great post!

I like the graph a lot: one line is missing though. If you had invested one dollar in residential RE in 1926, how many dollars would you have now?

That would settle the long-standing dispute with Chipman, who claims RE is better than stock market investments.

Of course he is wrong, and you can show it by adding an RE line: you can use the nominal returns provided by Shiller, or any urban economist, for major cities, or you can use the nominal yearly return computed by the Sauder business school for Vancouver. Whatever you use, just put it in the same graph with the stock market returns. People have to see with their eyes....

patriotz said...

I think those numbers are just price, i.e. capital gains. The return on RE is mostly yield as the real price tends to remain constant in the long run. Yield being net rental income, i.e. rent minus taxes, maintenance, etc. (but not financing costs as these are external to the asset).

RE definitely returns more in the long run than long government bonds. It has to, because it is more risky. Probably about 2% more annually.

But to claim RE has returned more historically than stocks is ludicrous. Even using today's absurd prices as an endpoint.

Warren said...

I wouldn't be surprised if RE returned about the same as large cap stocks. The risk is probably very similar. Certain metro areas would be way better over the last 80 years (Las Vegas), and some worse (Detroit).

patriotz said...

The risk is probably very similar

Nonsense, the risk is way, way lower. Isn't that obvious?

Earnings of RE, i.e. rents, are very predictable. Rents track inflation (more precisely wage inflation) very closely, which is exactly why RE prices track inflation, with a bit of upside, in the long run.

Even in times of recession, when even blue chip companies can lose money, nominal rents in big cities seldom decline.

Which is why RE total returns are far closer to bonds than to stocks.

Warren said...

Don't forget density increases. I was speaking specifically about Metro areas.

They are way higher than government bonds for sure.

ellery said...

I really like this blog, it is very sensible and helpful. I don't normally post, but today there is an hour long discussion of the US housing crisis on NPR's On Point program:

(I'm sorry I can't do fancy tags.)

If you search through the On Point archives, there is a show from 2005 with Robert Schiller, where everyone tells him he's being silly. It's fun to listen to, especially now.

domus said...

Likely that housing, when you include a 4 to 6% rental income, is better than government bonds.

Historically data (for Amsterdam and London, for example) tell us that housing gives consistently lower returns than stocks.

To keep it simple: if you invest one dollar each in RE and a stock index, the second will return much more after a 25 year period.

I really would love mohican to add housing income (inclusive of rental, net of costs) into the graph.

Vancouver RE will collapse badly to revert to the mean.

patriotz said...

Don't forget density increases. I was speaking specifically about Metro areas.

That is also predictable. Increased income through growth in density of RE is far more predictable than increased income from corporate growth.

jesse said...

"Earnings of RE, i.e. rents, are very predictable"

Yes but there is still risk associated with bad tenants, late rents, etc. OTOH there is likely a perceived control premium due to it being a tangible asset under one's direct control and possibly a premium due to it being well understood and, as you say, predictable.

The common mistake used in RE yield calculations is not accounting for one's time managing the property: spending weekends renovating, handling ongoing maintenance, and finding/advertising new tenants. Do you think landlords pay themselves the going rate for these tasks? It's an opportunity cost calculation but I never hold up much hope to properly explain this at dinner parties. The proper yield comparison includes a property manager.

jesse said...

"Increased income through growth in density of RE is far more predictable than increased income from corporate growth."

Agreed but still this has risk around zoning, changes in long-term population growth, gentrification, income growth/stratification, etc. Nevertheless it seems intuitive to put RE between government bonds and bluechip stocks.

(waiting for someone to bring up the leverage argument...)

patriotz said...

Well I will. Leverage has nothing to do with the return on the asset. It's just a way of raising capital.

Any investment can be leveraged.

That said, RE lends itself to leverage because, as I said, the yield is predictable (especially for owner-occupiers who do not face tenant risk), so it does not increase risk to the extent that it would for stocks, for example. But leverage of RE, or any other asset, only makes sense if the yield exceeds financing costs.

oh please said...

FV numbers are out, and they're surprisingly strong - SFH up 3.9% over January, although only 7.3% YOY.

Townhouses and apartments didn't fare quite as well.

But still. It ain't over yet, folks.

jesse said...

"so it does not increase risk to the extent that it would for stocks, for example."

I would argue that the timescale for successfully using leverage is long with real estate but the risk is still there. An extreme example is to look at Japan over the past 20 years. The point is one can get a false sense of perpetuity and for the past generation it has been akin to a free lunch.

patriotz said...

You are confusing adjustment of prices to fundamentals, which is a certainty, with risk.

Japan was in a bubble. Adjustment of prices to rents was a certainty. RE was not a risky investment in Japan in 1990. Real rents in Japan did not decline. It was just a very bad investment. As it was in the US in 2005, as it is in Vancouver now.

Risk means uncertainty of income. For example, in a single-industry town, the shutdown of the local employer is a risk to RE. Or the same in a big city like Detroit.