Blogs | February 15, 2012

Is owning a home worth the financial risk?

Housing is a riskier investment than many may imagine – particularly as prices tend to fall when jobs are at risk. And our birth dates may matter more than you think.

House prices have fallen sharply in many developed countries in recent times. In the United Kingdom, figures from Nationwide say prices are 11.1% down from their peak. Dutch statistics show a 10.9% fall in the Netherlands, in Spain they are 24.5% down and in the United States 33.5% down. Housing, then, is a risky investment. More risky, in fact, than you might imagine.

Timing hurts
The problem is not just that house prices have fallen. It is that they have done so at a bad time; when unemployment has risen and real wages have been squeezed – when, for many of us, the rest of our economic lives are also going badly. Housing has been a terrible store of wealth because it has fallen just when we most need wealth to tide us over during hard times. In this sense, houses are often a worse investment than shares. This is because shares sometimes fall when our economic lives are going well. They fell sharply in 2001-02, but this risk was tolerable for many of us because the labour market was strong and so we enjoyed wage rises that offset equity losses. Conversely, shares have risen since 2009, which means they have offered a little insurance against a weak labour market.

Are returns on housing worth the risks?
This raises the question: do the long-term rises in house prices offer sufficient compensation for this risk? Here, the basic economics of asset pricing can help. It tells us that the long-term return on an asset should depend upon four things:

  1. The volatility of the asset.
  2. The volatility of consumer spending. Consumer spending is a measure of good or bad times. The more volatile it is, the more likely are bad times, and the more likely they are to be really bad.
  3. The correlation between the two volatilities. An asset that does badly in bad times should offer us higher returns in good times to compensate for its tendency to let us down when we need it.
  4. A measure of risk aversion. The more we hate risk, the higher are the returns we need to induce us to bear that risk.

This framework tells us something important – that, over the long-run, housing should offer higher returns than shares. This is because the correlation between house prices and consumer spending (a measure of good or bad times) is stronger than that between shares and consumer spending.

Your birth date matters more than you may think
Whether this is the case, however, depends very much upon timing. For someone buying in the late 80s or since 2002, shares have actually done better than houses in the US. It is only someone who bought between 1997 and 2002 who is better off in housing than shares. Much the same is true for the UK.In this sense, housing has been a bad investment. It hasn’t offered us sufficiently high returns to compensate for its high risk.

Perhaps adding to frustration is that factors outside of our control have an influence here as well. The serendipity of timing can determine when individuals get in to the housing market. The date you were born can matter as home buyers typically have been through various life stages (such as completing education and getting a job) –. so many people might not have been at the right age to buy when houses were cheap in the late 1970s or early 90s.

We buy houses – not a housing index – upping the risk
You might object here that housing is safer than shares in that house price indices are less volatile than equity indices. Since 1987, the S&P 500 share index was only half as volatile as the S&P Case-Shiller house price index. But this is irrelevant for people buying a home. We don’t invest in a house price index, but in individual houses. Just as individual shares are more volatile than the index, so too are individual houses.

Don’t forget about the need to sell
In fact, housing is riskier than shares in another respect. It carries more liquidity risk, as it is harder to sell. Even in good times, contracts need to be organised, lawyers and estate agents briefed, fees and taxes paid and nobody can be sure how long it can take to complete the transaction. In bad times, the difficulties are even greater. It is no accident that buying and selling a property is considered one of life’s most stressful experiences. Housing should offer higher returns to compensate for this.

Why we shouldn’t abandon our love affair with housing
It doesn’t follow, however, that we should abandon our love affair with housing. It is a suitable purchase for at least two sorts of people. One is those who don’t have to worry about their labour income – either because they are retired, or are in a safe job, or have enough savings to afford to lose their job. If you’re this sort of person, the big risk with housing – that it’ll let you down when the labour market does – doesn’t apply to you. You are then in the happy position of being able to reap the long-term rewards of taking a risk that doesn’t trouble you personally.

The second class is those for whom buying housing, rather than renting, is a consumer good. If your dream house is for sale not rent, if you like doing extensive DIY, if you don’t like dealing with landlords, or if you feel a warm glow of ownership, then buying makes sense. The returns to owning a house don’t come merely from rising prices. It is this fact – which varies from individual to individual – that justifies (some) people owning their own house despite the financial risks involved.

Want to hear more from eZonomics? Sign up for our weekly newsletter.

InvestingSharesRiskHouse buyingHouse pricesRenting

Chris Dillow
Chris Dillow

Investors Chronicle writer and economist