The economics of long-term return on assets
Until a few years ago, when real interest rates slipped below zero because of high inflation, Indian households shifted their savings from financial assets. Financial savings are now picking up as inflation has been brought under control and real rates are back in positive territory. The rate of return plays an important part in investment decision and also influences the way resources are allocated in a society. Rising housing prices in the US, for example, led to over-investment in the sector and were one of the main reasons for the 2008 financial crisis.
The returns on various financial assets not only help households make investment decisions but also provide insights into broader issues such as inequality or financial stability. The problem is that there is very little independent data on asset returns over the very long term. All that we have are slivers of information which the financial industry uses to sell its products.
A new working paper The Rate of Return on Everything, 1870–2015 by Òscar Jordà, Katharina Knoll, Dmitry Kuvshinov, Moritz Schularick and Alan M. Taylor, published by the National Bureau of Economic Research, plugs this knowledge gap. The five economists have analysed returns on housing, equity, bonds and bills for 16 advanced economies including Japan, Switzerland, the UK and the US, between 1870 and 2015. The study, as the authors note, “provides researchers with the first non-commercial database of historical equity, bond, and bill returns, with the most extensive coverage across both countries and years, and the evidence drawn from our data will establish new foundations for long-run macro-financial research”.
Equities and residential real estate have shown similar real returns of about 7% per year. Housing did better before World War II, but after that, stocks have pulled ahead. However, this was accompanied by higher volatility, and booms and busts were more correlated across countries. This should not be surprising, especially in more recent decades, as trade and capital flows across national borders increased. Housing returns, however, have remained uncorrelated.
The finding that could surprise analysts and investors is that safe asset real returns have been very volatile, often more volatile than risky assets.
On average, returns on safe assets have been low. During peacetime, they have been in the range of 1-3% in most countries. Putting this in the current context, the paper notes: “Viewed from a long-run perspective, it may be fair to characterize the real safe rate as normally fluctuating around the levels that we see today...Consequently, we think the puzzle may well be why was the safe rate so high in the mid-1980s rather than why has it declined ever since.” Further, the risk premium has remained fairly stable during peacetime. It has gone up in recent years because of the fall in the risk-free rate.
Although the data used in the study is from advanced economies, the findings are no less relevant for a developing economy like India. Since the study spans well over a century, in a way, it takes into account the economic growth in these economies.
The biggest takeaway from the study is that in the long run, risk assets outperform safe assets by a significant margin. Also, in the long run, the real return on safe assets could be more volatile than commonly perceived. Therefore, on an average, households with equity and real estate in their portfolios are likely to do well over long periods of time.
Even though real estate has shown more stable returns, equity scores in term of the ease of ownership. While equity is more volatile, it is also more liquid. Further, it is easier to hold a diversified portfolio in equity than in real estate. But it is important to note that exposure to equity should depend on the risk appetite of individual investors, as stock markets can be fairly volatile and testing in the short to medium term. The study also shows that equity returns have a higher correlation with other countries which also increases the risk in the short to medium term.
The other important finding which has macroeconomic policy implication is that the real return on capital exceeds the rate of economic growth most of the time.
As economist Thomas Piketty has argued, if returns exceed the rate of growth, the rich will accumulate wealth and inequality will worsen. So if the return on wealth remains high for an extended period, as has been the case in advanced economies, inequality is likely to worsen. This poses a major challenge for policymakers. They need to design policies in a way that reduces inequality without disincentivizing savings, investment and wealth creation in the medium to long run.
That is a balancing act that is easier to propose than manage.
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