Another affordability question for youngsters discussion?

Discussion in 'Property Market Economics' started by TMNT, 14th Aug, 2017.

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  1. ollidrac nosaj

    ollidrac nosaj Well-Known Member

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    As pasted from AFR:

    How to invest if you rent and don't own a home

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    Home owners, the fact they are leveraged
    by Christopher Joye

    One of the biggest mistakes investors make—especially affluent ones—is to overlook what they started with when building a portfolio. If you already own a home, the manner in which you allocate the rest of your wealth should be materially influenced by the risk, return and correlation characteristics of the idiosyncratic property asset you have squirrelled away a large chunk of your savings into.

    The converse is also true: if you rent, the portfolio you construct should look very different to the home owner's holdings precisely because you do not need to factor in a hugely concentrated exposure to leveraged residential real estate.

    I made this point in a talk I gave on Thursday to KPMG's high net worth clients, who have typically generated most of their money from a specific entrepreneurial enterprise in a particular asset-class that can often dominate their portfolio for years to come.

    The reflex is to set up an investment strategy, or family office, outside of this business that neglects its ability to positively and negatively affect their long-term financial outcomes.

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    Renter: Optimal Portfolio Allocations Targeting CPI. Coolabah Capital Investments
    To quantify this point, I had one of my analysts set up two hypothetical investors. The first, whom we called the renter, is unconstrained in their ability to spread wealth around. The second, a home owner, is assumed to hold half their savings in one property.


    The challenge is to determine how much these investors should optimally allocate to local equities, global equities, cash, government bonds, corporate bonds, high yield debt, gold and property in order to reach their desired return target while minimising their probability of loss.

    In this exercise we used US financial market data because it is superior to what we have in Australia in both breadth and historical coverage. The US housing market has also experienced a decent drawdown whereas Aussie bricks and mortar has thus far been insulated from 10 per cent plus losses.

    My analyst employed a portfolio "optimisation" technique that selects the best combination of assets that deliver a target return of inflation plus 4 per cent, or just shy of 7 per cent annually, over the period 1988 to 2017 while minimising portfolio risk.

    This also happens to be the same return objective as Australian Super's "balanced" option and many other super funds. The last 30 years is as far as one can go back covering all these asset-classes and is a reasonable time horizon insofar as it captures multiple business cycles.

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    Home owner: Optimal portfolio allocations targeting CPI. Coolabah Capital Investments
    Where renters should invest
    If the renter had perfect foresight between 1988 and 2017, they would have put 47 per cent of their money into government bonds, 17.1 per cent into a single investment property, 14.6 per cent into high yield bonds, 13.5 per cent into cash, and just 7.5 per cent into local equities with no allocation at all to global shares. Doing so gives them a 7 per cent annual return with the lowest possible risk.

    One noteworthy result is the modest equity weight selected by the unconstrained investor, which pales in comparison to most super funds. (You get similar results if you use Aussie data.) The typical industry or retail super fund piles more than 75 per cent of their default portfolio into local shares, global equities, private equity, property equity, infrastructure equity and hedge fund equities.

    That is to say, they are taking on far too much equity risk for their inflation plus 4 per cent return targets, which over the last 10 years most have failed to hit precisely because of their equity drawdowns.


    Also note the nuance that the residential property allocation is actually to a single family home, not the overall housing market. To make the exercise realistic we scaled up the volatility of the national house price index several times to approximate the riskiness of an individual home, which is consistent with recommendations in the empirical research literature.

    Where home owners should invest
    The home owner makes very different decisions. With half their wealth locked-up in an individual property, the optimal portfolio choice is to allocate 23.4 per cent to government bonds, 15.8 per cent to cash, 8.9 per cent to high-yield debt, 1.9 per cent to global shares and an even smaller 0.3 per cent in gold.

    Observe that local equities play no role at all. Proportionately, this investor has huge amounts of housing risk, so they significantly reduce their exposure to similarly volatile shares, replacing it with more defensive fixed-income that sits further up the capital structure.


    This is interesting because around half of all super fund members own their home with the other half renting. They therefore require radically different solutions. If trustees took the time to recognise this fact, they might consider offering members "home owner" and "renter" options that account for their disparate wealth positions.

    In the case of home owners, the fact they are leveraged into idiosyncratic housing equity means they have an inherent appetite for more defensive (and uncorrelated) assets. In contrast, renters will have very different portfolio preferences. Of course, folks sometimes switch from one cohort to the other. At that juncture, they could also change their super fund options.

    To the best of my knowledge, no super fund yet offers these alternatives, which would presumably be very powerful from a marketing perspective. This idea is, however, related to, and a significant extension of, the notion of "life-cycle investing", which sensibly advocates adjusting the idealised portfolio composition according to a client's age and income needs.
     
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