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Not owning shares

Most households in the UK don't own equities. Many are correct not to do so
Not owning shares

Should you own equities at all? For some of you, the answer is: no.

Certainly, most people don’t own them. The ONS says that only 12 per cent of households own shares directly, and only 5 per cent own or unit investment trusts – although many more have pensions.

There are many reasons for this. One is simply that people can’t afford them: only one household in six has net financial wealth (excluding pensions) of more than £100,000. Another is a lack of knowledge. And another is loss aversion: those who would get much more pain from (say) a 10 per cent loss than pleasure from a 10 per cent gain won't see equities as a good deal.

But there’s more than this. For many, equities are less attractive than they seem – and not just because fund managers’ fees eat into returns.

We typically compare equities returns to cash. For example, in the last 30 years total returns on the All-S hare index have exceeded those on cash by 3.7 percentage points a year.

For many of us, however, cash is not the right comparator, as Yulia Merkoulova and Chris Veld at Monash University point out in a recent paper. When we consider buying equities what matters is the opportunity cost – the next best use to which we could put our money. If you have no debt, this opportunity cost is indeed the return you could get on cash or bonds.

If you have debt, however, things are different. If you have a mortgage, the opportunity cost of investing in equities is paying down some of that mortgage. What matters then is the gap between likely equity returns and the mortgage rate. With the latter over 3 per cent in many cases, this gap is small.

Of course, we cannot say how small, because there’s a wide margin of uncertainty around future equity returns even over long periods. It’s quite reasonable, though, for some people to avoid equities and instead pay off the mortgage.

This is especially true because for many of us equity risks are too high relative to their rewards.

To see why, consider why equities should have decent expected returns at all. It’s because they are risky. The risk that matters, however, is not mere volatility. An asset with volatile payoffs which did well in bad times would be a safe asset, and we’d accept negative returns to buy it – as we do when we buy insurance.

Instead, the problem with equities is that they could do badly in bad times, when we are losing our job or business and so most need wealth to tide us over.

Now, for many of us these risks to our earnings or business are tiny. If you’ve retired on a nice final salary pension or have a safe job you can ignore them. If you’re in this happy place, equities are a bargain for you as they pay out a risk premium for taking a risk that doesn’t trouble you.

For others, though, these risks are significant. If you could lose your job or business in an equity bear market then equity risk is huge as it means you’ll lose money on your investment portfolio when your losing other assets too. (Your job is an asset – hence the phrase 'human capital'). Even moderate levels of this background risk when combined with a modest positive correlation between that risk and equity risk can generate a higher risk premium than equities might deliver. Someone in this position would be entirely rational to avoid equities.

Seven-eighths of households don’t own shares. Many of them are right to do so.

For many of you, this is actually good news. If millions of people are rightly avoiding shares then their prices are low. And low prices mean decent returns for those people who don’t face big background risks.

Which brings us to something else. It’s often said that younger people should own more shares than older ones, as they have more years ahead of them in which to recoup losses. But this is not true in many cases – as Ravi Jagannathan and Narayana Kocherlakota pointed out in a classic paper 24 years ago. Many younger people face a low personal equity risk premium, because the alternative to equities is to pay off the mortgage. And they face higher background risk, too. This combination justifies many staying out of equities. By contrast, retired people who have replaced their risky jobs with a safe final salary pension don’t have background risk and so can buy equities. In many cases, therefore, equity ownership is an older person’s game.