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Unavoidable uncertainty

Uncertainty about the value of our biggest assets mean that it is impossible to optimise our portfolios, especially if we are young
February 8, 2018

Unless you’ve bought it recently, you probably have little accurate idea what your house is worth. This has important implications for how we invest, and indeed for the very nature of economics.

Let’s start with standard economics. This tells us that what matters when you think about investing should be your portfolio as a whole. Assets such as your property, business or earning potential should influence how you invest in shares; for example, if your job is vulnerable to a recession, it might be unwise to hold lots of cyclical shares.

And this is indeed the case. A recent study by Jose Fillat at the Federal Reserve Bank of Boston and colleagues has found that Americans who overestimate the value of their house tend to own significantly fewer shares than other people. And there are plenty of people who do misvalue their homes. They found that a quarter of home-owners overestimate their property value by at least 9 per cent.

You might find this surprising. You might imagine that people who think they are wealthier than they really are would feel able to afford more shares. And if people overestimate the price of their homes they might be overoptimistic in other ways, and so be more likely to buy shares.

These mechanisms, however, are offset by another. It’s that housing is a risky investment and an illiquid one at that. And if you have a large, risky, illiquid asset you are less able to take on other financial risks. Housing, in effect, crowds out shareholding.

This is amplified by something else. The higher you believe your house price to be, the more worried you are likely to be that it will fall: a high price is often another phrase for low expected long-term returns. This is especially likely to be the case if you’re using your home as an investment – say because you hope to trade down or use home equity release products. This makes you more reluctant to take on other financial risks. This explains an otherwise curious finding by Mr Fillat: that people who overestimate their house price tend to spend less than other people.

Misperceptions of house prices, therefore, distort our financial portfolios.

In themselves, these distortions might not be very important. After all, there are countless mistakes we can and do make.

Except for one thing: housing is not the only asset we have that we might value wrongly. There’s also our human capital; our ability to earn a living. This is prone to enormous uncertainty, especially for younger people: will you get that good job? Will your company thrive or not? Will you lose your job to technical change? And so on.

Whereas we might misvalue our house by a few per cent, uncertainties such as these mean younger people might well be an order of magnitude wrong about their lifetime earnings even if they are quite rational.

This too can seriously distort our investments. People who overestimate their future earnings are likely to save and invest too little when they are young in the mistaken belief that they will be better able to afford to do so when they are older and richer. They might therefore deprive themselves of some of the great benefits of compound returns. On the other hand, those who underestimate their future earnings might well save too much when they are young, thus depriving themselves of good times.

All this has more profound implications than you might imagine. It suggests that the standard economic advice – that what matters is your portfolio as a whole – is a counsel of perfection. Because we do not and in fact cannot know the value of big parts of our portfolio, we cannot get our asset allocation right. Optimisation is impossible. Theoretical models that assume it can be done are therefore fictions.

This implies that there’s a case for simple rules of thumb such as saving a stable proportion of our income each month and have a stable(ish) ratio of risky to safe(ish) assets. Such simple rules don’t optimise our portfolios. But they do, in the American economist Herbert Simon’s useful word, satisfice. Which is the best we can do in the face of uncertainty.

All this also highlights one of the great but underappreciated failings of our financial system – the absence of useful financial innovation. Way back in 1993 Robert Shiller – who went on to win a Nobel prize – proposed the creation of markets in human capital-linked securities that would in effect enable people to insure against some of the uncertainties surrounding their future incomes. This proposal has not been enacted, which shows how backward our financial markets are.

There is, though, something that governments can do about all this. Given massive uncertainty about our assets, even the most rational of us cannot save correctly for our old age: some will save too much and others too little. A high state pension helps protect us from these errors. One thing governments can do well is to pool risks.