A recent discussion with some relatives of mine in the course of my summer break got me thinking about the “no free lunch” concept that stands at the core of economic theory. Simply put, the famous sentence basically states that no return (in the sense of financial reward), can be obtained without incurring am equal measure of risk.
In general terms, there clearly is no arguing with that. Daily life throws enough examples of this theory in practice every day; think investing, new business creation, or even academic training where the “risk” is not only financial (as in hefty tuition fees) but also one of opportunity cost due to the time consumed. All in all, our parents and educators where right to drill into us, somewhat ungrateful souls, the concept of earning our keep by means of “effort” (read investment/risk) before “pleasure” (read return).
Returning to the afore mentioned discussion however, a casual reference made to the proportionality of risk to reward triggered my debating and sometimes controversial nature. The point made was quite simply (and logically) that no extra return can be earned without incurring a similarly larger, or “extra”, risk. Put simply, my counterparties at the discussion argued adamantly and in full conviction for the benefits of real estate as an investment class over stocks for the simple reason that they carried historically less risk. As a logical offshoot of this line of thought, stocks could possibly deliver better returns than real estate but only because they carried greater risk.
To me this is wrong on a number of levels. Having witnessed the performance of the real estate market in Spain over the last 25 years, of with the first 22 have been marked by a gravity-defying upward surge, and the last 3 by a stalling, slightly negative price trend and transaction-free marketplace, little opportunity remains for any price appreciation, nominal or real.
More seriously though, the simplistic argument that risk and return are linearly proportional does not hold in the cold light of historical asset performance. Not only have small-cap, low-priced “value” stocks delivered higher returns than their “growth” segment counterparts, but they have done so with less price volatility (I hate to used this measure of risk, but I feel compelled to do so, as it is the one referred to by those I am trying to enlighten).
Going back to the stocks versus real estate debate (after all, where else does a mere mortal put his or her money when interest rates are at 1-2%?), the flaws in the theory are even more evident.
For one, we already mentioned that price volatility as a measure of risk is almost meaningless, unless of course your investment horizon is truly short-term (in which case it begs the question of how on earth do you turn a real estate asset liquid without incurring a significant loss, not to mention a hefty tax bill)!.
A broader and more factually correct of looking at risk, (as in the probability of permanent loss of capital), would steer just about anyone in their right mind away from real estate investing in Spain right now. In the most basic of terms, supply is enormous and completely disproportionate whilst demand is minimal and dwindling due to reduced disposable income, critically high unemployment rates, tight credit standards (no lending) and artificially supported high prices (in saving bank’ pro-forma balance sheets) .
Even acknowledging that stock investing is a risky endeavour (and what isn’t?), in comparable terms, it offers plenty that real estate cannot match, such as liquidity, selectivity and much lower residual or holding expenses.
With this in mind, where would you bet today?
Gold mate.
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