As a completely independent advisor, I have no vested interest in how my clients invest.
Whether they invest in property, shares, or any other asset class makes no difference to my life.
Of course, I want them to invest in
- assets that are most appropriate for them and
- assets that provide the highest returns without taking an unacceptably high risk.
I know that if I help my clients invest successfully, they will continue to remain clients, and therein lies my firm’s success.
Often investors contemplate (and compare) investing in either property or shares.
The property versus shares debate is meaningless
It is often debated which asset class is better, property or shares.
I view this debate as arguing which golf club is best.
Each club has its unique purpose, and the reality is that golfers need many clubs in their bags to play well.
Investing is no different. Investing in a mixture of asset classes allows you to balance out the pros and cons of each asset class at a portfolio level.
Ignoring any one asset class in totality gives rise to higher investment risk as you are putting too many eggs in one basket.
In summary, I think shares and property are equally good asset classes.
I believe that most investors should invest in both.
I believe that if you employ an evidence-based approach, in the long run, the investment returns produced by property and shares should be materially similar.
The big difference is an investors’ appetite for gearing
Most people feel more comfortable borrowing to invest in property but less so with shares.
There is a good reason for that.
The chart below is from my book, Investopoly.
It sets out the long-term returns and corresponding volatility of each asset class.
The average volatility rate (or standard deviation) for shares is 20.9% and the average long-term return is 11.6% p.a.
To put this in non-mathematical terms, two-thirds of the time, you can expect that your annual return from shares to be in the range of -9.3% and 32.5% (being plus or minus one standard deviation from the average).
And 95% of the time your return will be between -30% and 53% (plus or minus two standard deviations).
That is a very wide range, right?
And that is why shares are seen as volatile, as the return can vary significantly from year to year.
However, residential property is a lot less volatile.
Two-thirds of the time your return will range between 0% and 20%.
And 95% of the time, between -10% and 30%.
Whilst this is still a wide range, it’s a lot tighter than shares.
That is why people feel more comfortable borrowing to invest in property because the likelihood of experiencing a loss year (just after you have borrowed to invest) is relatively low (i.e. there were only 6 loss years between 1980 and 2016).
How to borrow to invest in shares
I would almost never recommend someone borrow a large lump sum of money and invest it in shares in one tranche, for the reasons described above i.e. volatility.
Instead, I would usually recommend investing in a series of regular and relatively small tranches over (hopefully) many years.
Doing so helps you spread your market timing risk.
This can be a very effective strategy as explained in this video by Vanguard (watch from 1:30min).
This example shows that if you invested $500 per month in an Australian index fund beginning in 1990, that by June 2020 your investment would be worth $760,000.
This balance comprises $177,000 of your contributions plus $583,000 of investment earnings.
It shows that the strategy of making regular investments over long periods of time (30 years in this case) creates significant value.
All you need is the discipline to stick with it and patience.
Therefore, I would typically advise an investor wanting to borrow to invest in shares to do so on a regular basis, not in one lump sum.
Shares versus property: a practical comparison
I would like to compare two scenarios:
- Establish a loan against the equity in your home and draw $5,500 per month to invest in shares for 15 years i.e. $1 million invested; versus
- Borrowing $1 million today to invest in property.
Shares scenario
I have assumed a total investment return of 9.8% p.a., comprising of 3.7% of growth and 6.1% of income (this is based on the past 10-year performance of Vanguard’s growth index fund).
Other assumptions include a mortgage interest rate of 6.5% p.a., a marginal tax rate of 39%, and that the investor makes a cash contribution into shares equal to the investment property’s holding costs (i.e. the next scenario below).
Property scenario
The investor purchases a house in Brisbane for $940,000 and borrows $1 million to pay for stamp duty and buyers’ agent fees.
The property generates an initial rental yield of 3.2% and this rental income increases at a rate of 5% p.a.
The assumed long-term capital growth rate is 6.6% p.a. (so that the total return is 9.8% p.a. – same as shares).
The interest rate and tax assumptions are identical to the shares scenario.
And the winner is…
The chart below compares the value of equity for both scenarios.
It is obvious that property is the clear winner.
That is not because the property is “better” per se, but simply because the $1 million of borrowed funds were invested in full from day one (compared to $1 million invested gradually over the first 15 years).
What is the property capital growth breakeven rate?
The mathematical power of gearing can compensate for (or mask) poor investment returns.
The property strategy analysed above will be superior as long as the property’s average capital growth rate exceeds 5.85% p.a.
This means that it is possible that investing in a property that is sub-investment-grade could still work out to be a superior strategy.
Of course, I would never endorse investing in a property that is not investment-grade.
My point is to not underestimate the power of gearing.
The comparison is not fair, but it’s realistic and practical
As I have stated, the above comparisons have very different gearing levels, so of course, the scenario with a higher level of gearing produces superior results.
But we must not ignore the fact that gearing increases your investment risks as you have a larger interest rate exposure.
That is, you have an obligation to meet a property’s holding costs (from your salary or other resources), whereas the share strategy is self-funding (investment income pays for the interest costs).
It is not always appropriate for people to gear to the high level that is necessary to invest in property.
This risk factor must be considered.
Property can be better, but only because of gearing
The analysis above indicates that gearing into the property may allow you to accumulate 25% more equity over 30 years.
The property scenario above resulted in an equity value of $2.4 million in today’s dollars ($5.06m in future value) versus $1.8 million for shares (future value of $3.81m).
Whilst the differential is material at $600,000 in today’s dollars, considering that the shares strategy is self-funding, I’d argue that both strategies produce relatively good outcomes.
It’s probably more of a question of which strategy suits your circumstances and goals best, rather than which is the better asset class.
from Property UpdateProperty Update https://propertyupdate.com.au/property-versus-shares-a-practical-comparison/
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