“The rate of return on everything”

This is the focus of a paper titled “The Rate of Return on Everything, 1870-2015 that seeks to address some fundamental questions that underpin, not only economic theory, but also investment strategy.

To quote the abstract:

This paper answers fundamental questions that have preoccupied modern economic thought since the 18th century. What is the aggregate real rate of return in the economy? Is it higher than the growth rate of the economy and, if so, by how much? Is there a tendency for returns to fall in the long-run? Which particular assets have the highest long-run returns? We answer these questions on the basis of a new and comprehensive dataset for all major asset classes, including—for the first time—total returns to the largest, but oft ignored, component of household wealth, housing. The annual data on total returns for equity, housing, bonds, and bills cover 16 advanced economies from1870 to 2015, and our new evidence reveals many new insights and puzzles.ets.

“The Rate of Return on Everything” Òscar Jordà, Katharina Knoll, Dmitry Kuvshinov, Moritz Schularick, Alan M. Taylor – December 2017

The paper is roughly 50 pages long (excluding appendices) but the 5 page introduction summarises the four main findings which I have further summarised below:

  1. Risky Returns: The study finds that “… residential real estate and equities have shown very similar and high real total gains, on average about 7% per year. Housing outperformed equity before WW2. Since WW2, equities have outperformed housing on average, but only at the cost of much higher volatility and higher synchronicity with the business cycle”.
  2. Safe Returns: The study finds that “Safe returns have been low on average, falling in the 1%–3% range for most countries and peacetime periods“. However, “the real safe asset return has been very volatile over the long-run, more so than one might expect, and oftentimes even more volatile than real risky returns.” This offers a long-run perspective on the current low level of the safe returns with the authors observing that “… it may be fair to characterize the real safe rate as normally fluctuating around the levels that we see today, so that today’s level is not so unusual. Which begs the question “… why was the safe rate so high in the mid-1980s rather than why has it declined ever since.”
  3. The Risk Premium: The study finds that the risk premium has been very volatile over the long run. The risk premium has tended to revert to about 4%-5% but there have been periods in which it has been higher. The study finds that the increases in the risk premium “… were mostly a phenomenon of collapsing safe rates rather than dramatic spikes in risky rates. In fact, the risky rate has often been smoother and more stable than safe rates, averaging about 6%–8% across all eras” . This for me was one of the more interesting pieces of data to emerge from the study and has implications for the question of what should be happening to target return on equity in a low interest rate environment such as we are currently experiencing. In the Authors’ words “Whether due to shifts in risk aversion or other phenomena, the fact that safe rates seem to absorb almost all of these adjustments seems like a puzzle in need of further exploration and explanation
  4. On Returns Minus Growth: This is the question that Thomas Piketty explored in his book “Capital in the Twenty-First Century”. Piketty argued that, if the return to capital exceeded the rate of economic growth, rentiers would accumulate wealth at a faster rate and thus worsen wealth inequality. The study finds that, “for more countries and more years, the rate of return on risk assets does in fact materially exceed the rate of growth in GDP… In fact, the only exceptions to that rule happen in very special periods: the years in or right around wartime. In peacetime, r has always been much greater than g. In the pre-WW2 period, this gap was on average 5% per annum (excluding WW1). As of today, this gap is still quite large, in the range of 3%–4%, and it narrowed to 2% during the 1970s oil crises before widening in the years leading up to the Global Financial Crisis.

So why does this matter?

There is a lot to think about in this paper depending on your particular areas of interest.

The finding that the long run return on residential housing is on par with equity but lower volatility is intriguing though I must confess that I want to have a closer look at the data and methodology before I take the conclusion as a fact. In particular, I think it is worth paying close attention to the way that the study deals with taxation. Fortunately, the paper offers a great deal of detail on the way that residential property is taxed (Appendix M in the December 2017 version of the paper) in different countries which is useful in its own right. I have been looking for a source that collates this information for some time and this is the best I have seen so far.

For me at least, the data on how the Equity Risk Premium (ERP) expands and contracts to offset changes in the return unsafe assets was especially interesting. This observation about the relationship is not new of itself but it was useful to find more data in support of it. I have been thinking a lot about Cost of Equity in a low interest rate environment and this seems to support the thesis that the target Return on Equity (ROE) should not necessarily be based on simply adding a fixed measure of the ERP (say 4%-5%) to whatever the current long run risk free rate is. It is at least worth having the question in mind when considering the question of whether Australian bank ROE is excessive at this point of the cycle.

If you are interested in the issues covered above then it is also worth having a look at an RBA Research Discussion Paper titled “A History of Australian Equities” by Thomas Matthews that was published this month.

From The Outside

Author: From the Outside

After working in the Australian banking system for close to four decades, I am taking some time out to write and reflect on what I have learned. My primary area of expertise is bank capital management but this blog aims to offer a bank insider's outside perspective on banking, capital, economics, finance and risk.

3 thoughts on ““The rate of return on everything””

  1. I’d agree, Tony, that the housing returns are much less well measured than bond or equity returns.
    You may have seen that the authors generously acknowledged my comments on this very topic. The
    correct calculation of returns when there are investment and other cash flows is quite complex and
    errors accumulate.




    1. I missed that Philipp but I now hold this paper in even higher esteem now that I know you contributed. I think it would be interesting to further distinguish owner occupied housing from investment properties. The paper for example dismissed land tax in Australia as significant but it can have a big impact where you invest in houses as opposed to apartments.


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