Here is a very powerful but simple explanation of why real estate investment is better than investments in the stock market or other financial instruments. For some reason, I have not heard this explanation back in University while doing both bachelor’s and an MBA degree and knowing this earlier, would made me rich.
When investing into real estate, one would usually get a mortgage, which is basically bank providing you with substantial leverage, something you would not be able to obtain even when trading on margin. For example, you could be investing $100,000 of your own money for downpayment, while getting another $400,000 in mortgage. When real estate grows at 5% a year, your property appreciates by $25,000 ($500K*5%). Looking from the perspective of your original investment of $100,000, you have just made 25% on your money, virtually on a risk free investment.
I doubt most individual investments would ever be investing in stock market on margin. Even if stock market growth was double the real estate market growth, you would still only make 10% on your money ( $100K * 10%).
Even if real estate grows at the rate of inflation of 3%, an investor still is gaining 15% on their money given leverage of 1 to 5. What if they are leveraged 1 to 10? Then the real gain is 10x.
There are years when real estate is growing at 20% a year. Someone who was leveraged at1 to 10, would be gaining 200% on their money on virtually a risk free investment! Find me another asset class that would do this. This explains what looks like an insane growth of real estate markets over the last few years in certain markets.
Of course, there is an issue of a real estate bubble, memories of the 2007/8 housing crash but I would argue that in the long term real estate would still grow, especially in the big urban markets, driven by the urban population growth, immigration, and money printing by the central banks.
Obviously, this logic would not work 100% of the time, some markets are significantly overpriced and could experience even long term real estate price declines (example of Japan comes to mind). An investor over-leveraged in a declining market, could erase their equity in their home. But the good news, there will not be a margin call, you could still own your house or rent it out, and pay it off over long periods of time with housing markets likely to recover – hence my premise of a virtually risk free real estate investment.
There are many other factors to consider such as taxes, maintenance costs, proximity to growing real estate markets, long term population trends but generally, for a regular person, living in a big urban center, this logic holds.
Country’s Nominal GDP is measured in US dollars unadjusted for relevant prices between countries, i.e. the dollar value of all goods and services produced. Purchasing Power Parity GDP (PPP GDP) tries to adjust for the differences in prices between countries, balancing things out and showing a more fair comparison between countries.
Here are a couple of easy examples to explain the difference. A same haircut in Indonesia will cost a fraction of a cost in US, e.g. $2 vs. $20. However, it may be exactly the same haircut and thus, people in Indonesia cannot be considered worse off, i.e. the relevant contribution to GDP should be judged similarly. Another example, is a price of McDonald’s Big Mac in various countries. It may cost $5 in US but only $1.50 in Eastern Europe. Again, it is more or less the same Big Mac, and its contribution should be the same across countries. In fact, there is a Big Mac index that estimates the fair exchange rate between currencies for different countries based on this discrepancy.
The differences are largely driven by services because they are dependent on human labor, with the main input being employee salary. This widely varies across the world causing such differences. On the other hand, commodities are traded on global exchanges and their price is very similar around the world, so it does not really explain the differences in price levels and GDPs between countries. Exceptions to the rule exist (e.g. price of gasoline) as some countries have abundance of a particular resource (e.g. oil) and/or government subsidies.
The difference between nominal and PPP GDPs are more pronounced in Emerging Markets (e.g. Indonesia, India, Russia) where salaries are relatively low. PPP GDP there can be significantly higher than Nominal GDP. The differences are less pronounced in developed markets. Some markets may appear rich in nominal terms but are lower in PPP terms (e.g. Norway) because things are generally more expensive there even though salaries are high.
USA vs. China GDP (Nominal and PPP)
One interesting case of Nominal vs. Purchasing Power Parity GDP occurs between USA and China. Many scholars argue, which economy is bigger. That is dependent on whether you are considering nominal or PPP economy size. As of 2020 data (this article is published in May 2022), USA was much ahead in nominal terms but was significantly trailing in PPP terms. See the graph below explaining the difference. So which economy is bigger in your opinion? Also, note how both figures are the same for USA as PPP is measured in current US dollars.
We often hear about over-population, and many of us feel it through ever growing population in our big cities, immigration, and increasing real estate prices driven by more and more people pursuing fewer and fewer homes. Are there too many of us?
Certainly world’s population and population of many developed countries continues to grow. However, you may be surprised that it is growing at a decreasing rate and the declining trend has been there for years. We are now passing the 1% growth mark but it is certain that the rate is to decline further.
What are the two key variables of world population growth – 1) fertility rate measured by the number of kids per woman and 2) increase in expected life span. While longevity is hugely important for particular individuals, it has a somewhat temporary effect as life span tends to level off when country’s life expectancy reaches low 80s. In addition, retired individuals have a relatively low effect on economic growth as most stop working and consume less.
With this in mind, fertility rate becomes the primary metric that defines long term population growth. Let’s take a look at world’s fertility rate.
As you can see the trend is declining. While in 1960, women had 5 kids on average per woman, it is only 2.4 now. The sustainable birth rate is 2.1 babies per woman – this insures population growth is essentially 0 (the additional 0.1 is a reflection of some infants dying during birth). So we are getting close to this figure. Once below, the population will start declining. In fact, Elon Musk considers the population decline as one of the key threats to the long term survival of our species.
It is a known fact that most of the population growth and babies are in the developing countries. In fact, it seems that generally women in poorer, less developed countries tend to have more kids. Research has shown that this may have to do with the general level of women’s education. There are more highly educated women in developed nations that pursue careers, taking time away from having more babies. Of course, there are many examples of highly successful career-oriented women who also have many children but those mothers are extra-ordinary. A day does have only 24 hours, and the little ones do require a lot of time.
Let’s look at the G20 countries demographics, specifically focusing on the following 3 metrics: 1) fertility rate, 2) population growth, 3) a proportion of population with kids 0-14 years of age. The below table is essentially a demographics scorecard.
We generally indicate a positive value of the metric in green. In yellow, the metric is concerning. In red, things are really negative.
For birth rate (fertility rate), any value above 2 was marked green. Between 1.5-2 in yellow and below 1.5 in red. South Korea scores really low on the this metric. In fact, South Korean women have less than 1 baby on average, which is essentially a demographics time bomb in the making. Canada is another surprising member of the low birth rate list with just 1.47 kids per women despite high population growth rate.
China, US, UK, Germany and Russia all have low fertility below the sustainable birth rates. South Africa, Saudi Arabia, Argentina, Indonesia and India have positive fertility rates. Interestingly, India world’s second most populace country has this rate rapidly declining and potentially permanently hitting below 2.1 as a result of covid epidemic.
Population growth rates (average over the last 5 years) below zero, i.e. declines, were marked in red; below 1% in yellow and above 1% in green. The story here is very similar to the fertility rate – no wonder, population growth is a trailing indicator and as mentioned before, is driven by birth rate and growth in life expectancy. The other factor influencing population growth is immigration, and that is why both Canada and Australia, countries with high immigration, score positive on this metric despite low fertility rates and virtually maxing out on their citizens life span.
Proportion of population between 0 and 14, i.e. population of kids, very much follows the same pattern. Again this is a trailing indicator to a recent fertility rate (although there is a bit of a lag).
In Summary: World population is set to decline
In summary, we still see world population growing albeit at a decreasing pace and sooner or later, it will start declining. The primary cause of this is falling birth rate among women, especially in more developed countries. As frontier market economies develop, we are likely to see even further declines in the world fertility rate and ultimately a world population decline.
Developed economies populations will continue to grow for the foreseeable future solely because of immigration. The pace of growth will also be low as there is only so much immigration, a country can absorb.
Population Effect on Economic Growth and Markets
Population growth is one of the key drivers of the long term economic growth (the other being technological progress). With population growth in doubt, the pace of economic growth is also bound to decrease. This should also have an effect on stock market growth, which we predict to slow down given aging and soon-to-be declining populations. Fewer consumers = fewer profits. Fewer people = fewer workers = lower economic output.
However, which markets will grow and what is the optimal investment strategy? United States and emerging markets seem to be better bets given presence of both technology and population growth. Developed markets could see slower growth in the medium to long term as they are already facing population decline.
Thus, I propose a a long term equity portfolio of 45% US, 30% Emerging Markets (EM) and 25% Developed Markets (DM excl. US). This proportion is overall aligned with the size of the economies and stock market but is overweight in Emerging Market stocks vs. a current distribution of a global stock index (e.g. Vanguard total stock index).
The proportion of portfolio in bonds will depend on how close one is to retirement and current interest rates. In case of major market downturn, investors close to retirement could be forced to sell equities at lower prices; instead selling bonds would be more prudent while waiting until equities recover. Also, low interest rates today mean there is really no upside to the bonds value. If in the future rates do go up, and later, there is a potential for another downward rates spiral (e.g. rates 5% to 1%), bond values will rise. So when rates peak, bonds should be added to one’s portfolio.
Flexible Asset Allocation
The weights of the 45% US (we prefer to invest in SP500), 30% EM and 25% DM portfolio should also have a degree of flexibility depending on how a specific asset class is valued. This can be assessed through something as simple as the Price-Earning (PE) ratio. (why complicate things) I like to set a threshold in PE ratios. If a certain market reaches the threshold, I start to decrease its weight and automatically increase the weight of assets that are still competitively priced. If all of the 3 assets classes start to look significantly overpriced, I sell into cash and bond equivalents. Of course, there is a degree of judgement when setting a threshold and starting to decrease weights. PE ratios can sometimes be misleading, especially in times of significant downturns when profits are really low – this was the case during the 2008/09 subprime crisis when SP500 PE was at 123.73!
However, let’s take an example of SP500 in 2020/2021 and a perception of it being overpriced. PE ratio reached 39.26 on Dec 1st 2020 and continued to be in mid 30s until March of 2021. In comparison, PE ratios of Developed and Emerging markets were at high teens / low 20s. At that point, I have rebalanced my portfolio to being underweight in US stocks. This of course proved a bit premature as SP500 continued to rally through 2021. Closer to the end of 2021, beginning of 2022, SP500 PE ratio has declined to about 25, which I consider in line with a fairly priced given the low interest rate environment, and I have started to rebalancing the portfolio closer to the model figures. Should the interest rates increase, the PE ratio threshold may be adjusted downwards. I am yet to create a formula to derive PE threshold depending on the current interest rates.
So, I have shown the logic behind my model portfolio allocations and how to deal with proportions based on how expensive the various asset classes get. You may use this logic to create your own portfolio with your asset allocations depending on risk appetite, objectives and level of comfort with a given market class.
Now, to the question of market timing.
It is virtually impossible to predict local peaks – we have tried and mostly failed over the years as the market continued booming. We do think that the adjustments in market allocations based on price-earnings ratios shown above are able to counter the risk of major losses if the market gets overheated. However, recognizing that the market always goes up in the long term, we consider strategy of market selling a losing strategy over time.
Instead we can focus on when to buy equities, putting an emphasis on local bottoms. That is not say that we should not be buying in the normal course of market performance. Indeed, regular contributions to your portfolio should be maintained regardless of the market conditions.
However, any significant decreases in market indexes present a great, almost guaranteed way of increasing your wealth. When markets tank 20, 30, 40 and 50%, it is a great time to get into the market. Our plan is to use leverage next time the market significantly drops and continue buying, and borrowing as long as market continues to decline. With markets at historic heights, we know for a fact, that we’ve always recovered, no matter the extent of the downturn. Sometimes, it takes years to fully recover, however that growth still significantly exceeds any alternative investments and borrowing costs. For example, if it takes 5 years to return back to the previous peak from a 50% drop, you have still made 100% on your investment if you’ve purchased at the bottom over a 5 year period, or 15% per year.
When market is dropping, it is best to maintain discipline and build an investment strategy ahead of time. For example, you think that market has a potential for a 40% drop and that you are willing to invest $60,000. You can invest the 1st $20,000 when the market enters the bear territory and declines by 20%. The 2nd $20,000 can be invested if a market declines by 30%, the last $20,000 if market declines by 40%. This strategy ensures you are disciplined, don’t over invest too early, or be too greedy, e.g. still make money if market only drops 20%.
Optimal strategy summary
Invest into a diversified portfolio of global stocks with weights you find appropriate but relying on key market drivers of technology, population growth and money supply growth. Consider investing into bonds, cash or alternative investments if closer to retirement.
Be flexible in your allocation depending on relevant valuation of the asset class; adjust if PE ratios of a given asset class imply overvaluation. However, be mindful that PE ratios are imperfect
Don’t try to time the peaks. However, have a strategy to enter the market during times of turmoil and significant market declines. Consider using leverage.
Disclaimer: This article is for general education purposes and cannot be relied upon as individual investment advice. This is our optimal investment strategy, however it may not be suitable for your unique circumstences.
Markets historically have always grown when viewed from the long term perspective. Market growth is a representation of increases in the wealth of our society and the many business that it comprises of. The three main drivers of this growth are technology, increase in money supply and population growth the years. I think we can be confident of the first two factors to continue. It can be argued of whether technology growth accelerates or decelerates, however continuous improvement, human ingenuity and drive towards progress seem to be at the heart or a brain of our species existence.
Money supply growth also seems to be the key component of our economic structure. This is seen in central banks’ long term tendency to decrease rates to keep credit flowing, and more recent economic stimuli by governments via cash payments directly to citizens and ever-growing budget deficits. There could be temporary changes in this trend, such as credit tightening, balancing of the books but it seems overspending and credit growth have been now engrained in our economic institutions policies and actions, and this trend is unlikely to reverse.
Long term population growth is under question as most developed and emerging markets have sub-replacement fertility rate (i.e. lower than 2.1 children per woman). This trend has been visible for over a decade now but is only now becoming more visible and talked about. Of course, many developed nations substitute their natural population declines and stagnation through immigration, however the downward sloping trend is present even in countries with still high fertility rates. So, it seems it is a big yellow flag in the long rim, however will not be felt in the short-medium term in United States and Western Europe. Japan, South Korea, Eastern Europe and China are already suffering from this trend.
In addition to the market drivers, there are many prerequisite to this growth such as presence of free markets, sound legal and banking systems, level of trust between market participants, sophisticated logistical chains and availability of resources. I am not over optimistic that we’ll make any great gains in the above parameters; quite contrary it seems there is slow erosion, at least in the developed markets. Even more pessimistic is future availability of natural resources given our tendencies to over-consume with things generally becoming more scarce with time. This is offset by technological developments, especially in energy and use of new materials that make us more efficient.
So, my conclusion is that markets will continue to grow long term, however at a slower pace.