A Canadian's random thoughts on personal finance

Apr 23, 2009

Pessimism and the Risk Premium

The Dividend Guy has posted an article discussing market rebounds after downturns. This effect could be explained statistically by reversion to the mean, but this doesn't give any insights to the causes of the phenomenon, which I think is quite easily explained.

An investment with higher risk must, if fairly priced, give a higher expected return. This phenomenon is referred to as the risk premium. Now, in an efficient market, when some bad news comes to light, investors adjust their expectations for future earnings, and stock prices drop to maintain a fair P/E ratio. However, investors also conclude that risk has increased, causing them to demand a higher return, which implies a lower P/E ratio, so prices drop further.

When the bad news ends and good news starts to roll in, prices will initially grow along with higher expected future earnings; and then the perception of risk drops, causing the P/E ratio to grow again.

So, for example, suppose we learn that company ABC's expected earnings will be half what they were thought to be. For a fixed P/E ratio, this means that the stock price should be half what it was. However, this bad news also leads to increased perception of risk, so the P/E ratio drops, and the stock price can end up much lower than half of what it was.

Conversely, when the bad news ends and the expected earnings double, the stock price would merely double if not for the risk premium; but when the risk premium disappears, the P/E ratio increases, and the stock price can end up much higher than it was.

Without the risk premium, P/E ratios would remain fixed. Thanks to the risk premium, P/E ratios fluctuate with the market mood. This is a good thing for those with longer investment horizons: they are less risk-averse, and can pick up some good bargains during times of pessimism.

Lower P/E ratios during times of pessimism explain why returns would be higher during those times, causing overall stock performance to revert to the mean. This explains one small part of why Warren Buffet has had so much success being greedy when others are fearful.

Apr 21, 2009

Still renting?

A year ago, I posted my most popular article yet: Save money by renting your home. A lot has changed in the last year, but one thing that's the same as ever is that I'm perfectly content renting for the foreseeable future.

The the article hinged on a calculation of the largest mortgage I could carry and still save money every month:

I pay $1200 per month in rent, including my parking space. That rent includes a number of items that would come out of my own pocket if I owned a home, such as property tax, repairs, maintenance, and some utilities. All told, I get about $500 in value every month included in my rent. That leaves $700 that is truly "thrown away" just like mortgage interest.

How large a mortgage would cost $700 per month in interest? Today's variable-rate mortgages are going for about 4.6% per year. At that rate, a mortgage of $182k would have interest charges of $700 per month. That means if I could stop renting and move into a house with a mortgage of $182k or less, I would save money every month.
Here's what has changed:
  • My rent has increased by $50/mth. That brings my "thrown away" money up to $750/mth.
  • Variable-rate mortgages can now be had for 3.05% interest.
With these new figures, we find that the magic mortgage number is now about $295k. If I can find a buy a home with a mortgage of $295k or less, I would save money every month.

Here's what hasn't changed:
  • Homes in my area still don't go for $295k. They're still up around $480k.
  • Condos can be had for $295k, but the condo fees move the break-even point below $295k, so they're still not better financially.
  • I still don't particularly want to own a home.
I'd like to leave you with one final thought. It is being claimed that now is the time to buy a home because of increasingly favourable interest rates and home prices. To my mind, the best time to make any investment is when the price is low and increasing. Right now, real estate prices are high and decreasing. As far as price is concerned, you could hardly choose a worse time to buy a home than right now (except perhaps six months ago).

The worst has happened. The sky has fallen. I've lost a gut-wrenching amount of money on paper in the stock market since September. But I'm as satisfied as I ever was in my asset allocation, my risk tolerance, and my decision to rent rather than buy.

Update, Apr 21: As of this week, you can get mortgage rates as low as 3.05%, so I have adjusted my calculations above to use this number instead of 3.3%.

Update, July 15: Looking at the same link given above, we see now that variable mortgage rates are as low 2.85%, so the break-even mortgage is up to $315k. This means I probably could buy a house in my neighborhood and, ignoring the buying and moving costs, I might save a few bucks every month starting on day one. But I still have no interest in buying a house just yet. For one thing, the moment the mortgages return to more historically normal rates, the mortgage's advantage over renting disappears, and I would be back to losing money every month relative to renting. I consider it unwise to bet against this happening in, say, the next five years. There are also non-financial considerations, like the freedom to change homes with just 60 days' notice at no cost, or my nearly complete protection from risk in the real estate market. A house would need to cost substantially less than my rent for me to take on the extra risk and responsibility of house ownership.

Update, November 3: Now rates are down to 2.25%, so the break-even mortgage is up to $400k. If I were convinced mortgage rates would stay this low indefinitely, and I liked the idea of skewing my asset allocation heavily toward residential real estate, and I didn't mind mowing my own lawn and fixing my own roof/furnace/toilet/whatever, and I was ok with losing the freedom to move with 60 days' notice, I'd buy a house right away!

Update, November 24: The neighbors just sold their house for $650k. It was a decent-sized 5-bedroom house, but it just goes to show that I wasn't being overly pessimistic by estimating $480k.