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Housing as diversification

Housing has been surprisingly effective as a way of diversifying stock market risk
October 5, 2018

Housing might have more of a role to play in a balanced portfolio than you think.

I say so for a simple reason – it can diversify away some types of equity risk. My table shows the point. It shows the performance of the Nationwide house price index, adjusted for inflation, during the five worst bear markets for equities since 1970. During three of these five bear markets, house prices actually rose nicely. An investment in housing would therefore have done a good job of diversifying equity risk.

House prices during equity bear markets 
DateAll-Share indexHouse prices
March 72 - Dec 74-76.221.5
March 79 - Sep 81-30.0-4.9
June 87 - Dec 88-24.525.9
Dec 99 - March 03-48.355.3
June 07 - March 09-44.2-21.2
Adjusted for RPI inflation 

You might find this surprising: I did. Common sense says house and share prices should both depend upon the state of the economy and interest rates and so should rise and fall together. And there is some truth in this. The two occasions when both fell were both deep recessions. Housing does not spread the risk that a recession will cause a slump in share prices.

It does, however, do a nice job of protecting us from two other dangers.

One is distribution risk – a shift in the distribution of national income from profits to wages. This happened in the early 1970s, and caused house prices to rise as shares slumped.

The other is valuation risk. Sometimes, shares simply rise too far and subsequently correct themselves. This happened in 1987 and 2000. When these bubbles burst, house prices hold up well and so helped to cushion stock market losses. 

Housing, then, can be part of a balanced portfolio. But this comes at a price.

This price is not necessarily foregone returns. Historically, house prices and share prices have done about as well as each other, depending upon when you start the comparison. In price terms, the All-Share index has outperformed houses since the mid-late 70s and mid-00s. But housing has outperformed since the early 70s or mid-90s. Yes, this comparison excludes dividends and the fact that housing costs money to insure and maintain. But it also excludes rent or the satisfaction one gains from living in a home of your own; the latter is undoubtedly important but varies so much from person to person that we cannot generalise.

Instead, housing carries dangers compared with equities.

One is of a disorderly Brexit. Bank of England governor Mark Carney was probably being overly precise when he recently warned that this could cause house prices to fall by 35 per cent. But there is perhaps some truth in his warning: expectations of lower incomes plus simple uncertainty might well hurt the market in such a scenario. Equities, on the other hand, might not suffer so much because a weaker sterling could support those that have lots of overseas earnings.

A second danger is that houses are hard to sell quickly, especially in bad times. They are a terrible asset for anybody who might need to raise cash quickly – and one of the first rules of investing is to never, ever be a forced seller.

Thirdly, bear markets in housing can be much longer than bear markets in equities. In real terms, house prices did not return to their 1989 levels until 2001. And even today they are lower in real terms than they were in 2007. If you buy a house at the wrong time you can easily spend 10 years under water.

There’s a reason for this. Home owners are even more reluctant than shareholders to sell at a loss. In bad times, therefore, they hold out for unrealistically high prices or take their property off the market. The first response to hard times is therefore not a crash in prices but a lack of transactions. Prices only gradually drift down as reality bites. Shares, by contrast, react quicker to bad news and so bear markets tend to be shorter and sharper (although of course, this does not rule out a protracted drop in shares in the future).

Finally, it’s possible that housing is more expensive than equities now. Whereas the dividend yield on the All-Share index is around its long-term average, ratios of house prices to earnings or rents are high. And the ratio of house prices to share prices is also above its long-run average. Valuation risk, therefore, is probably greater for housing than for shares.

On the other hand, some lead indicators do point to poor equity returns, such as the ratio of the global money stock to share prices. And we must not rule out the possibility of a shift from profits to wages – caused either by a tighter labour market or by a future Labour government – that would support house prices at the expense of equities.

On balance, then, there might be a case for holding some housing as a way of diversifying some types of equity risk. This does not mean you should become a buy-to-let landlord. It simply means that if you are one of those people who has lots of equity in their home and are considering the possibility of downsizing later you are entirely sensible.

The old advice that your house should not be your pension is sensible in the sense that it should not be all your pension – although I suspect it is motivated in part by the fact that financial advisors and fund managers don’t get fees from your house. But perhaps it should be some part of your pension.