There seems to be an inverse relationship between an investor’s purported level of sophistication and their returns in recent years. At least, that’s what one might assume when comparing the historical aggregate return of US households with that of the hedge funds community.
Using data from the Federal Reserve, Gaurav Chakravorty and Amit Sinha explained in a column for MarketWatch how since 2003, the average American household has earned a greater return on investment than the average hedge fund. What accounts for this achievement gap? The two authors explain that households typically don’t invest their wealth like “day traders” or “return chasers.”
They operate more like “skilled portfolio managers” who “appear to be rational actors.” In other words, they rarely adjust their portfolios.
Households also outperformed hedge funds while taking on a similar level of risk.
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“We estimate that since 2003, the average household has earned more than 4.5% a year from their investments. While 4.5% annual return may sound low at first glance, especially given that the S&P 500 SPX, +0.19% returned about 9.5% over the same period, U.S. households achieved these returns by taking half the risk of S&P 500.
Furthermore, these returns exceed the returns from a diversified hedge fund index, which earned just 1.6% a year.”
The outperformance in household returns is due, in part, to their savings rate, which allows to build on their investments, and higher rates of diversification.
“Households continued to steadily add to their savings over the study period, and their investments were evenly spread across many different assets — such as stocks, bonds, real estate and pensions — as opposed to being concentrated in a single asset, such as real estate.”
While real-estate has historically comprised nearly a third of household wealth, that dynamic has changed since the beginning of the bull market in 2009. Since the crisis, stock-market gains have been primarily responsible for repairing household balance sheets, instead of real estate.
“Real estate hasn’t driven the repairing of household balance sheets. In the run-up to the 2008 financial crisis, real estate was one of the largest contributors to household wealth and represented about 32% of total wealth. After the financial crisis, real estate has been hovering close to the lowest historical levels at around 24% of total assets.”
While this might sound surprising to some, the reason is because stricter lending standards adopted since the crisis have made it more difficult for people to become homeowners. Meanwhile, an increasing number of homes are being purchased by foreigners, or by real-estate partnerships.
“Initially, this may appear surprising, given the run-up in real-estate prices in most parts of the country. However, a further analysis shows most households haven’t participated in the latest boom. Bank lending standards are stricter than before, with over 60% of new mortgages going to borrowers with excellent credit scores, as compared with only 25% before the 2008 financial crisis. In addition, an increasing portion of homes are being purchased by foreign buyers and real estate partnerships.
When we combine these factors with one of the strongest bull markets since 2009, it’s why the stock market has become a bigger driver of household wealth creation than real estate.”
Going forward, mom and pop investors should be careful about managing their risk exposure, as a growing share of their wealth is being bound up with equity prices. At 35% of total assets, household allocation to stocks are near historic highs. Before the dot-com bubble, stocks represented less than 30% of total assets, but peaked at 38% during the height of the dot-com bubble.
One reason for this is the change in how we save for retirement, with 401(k)s and private plans taking the place of defined-benefit contribution programs.
“…household wealth is exposed to stock markets through pensions and entitlements, as 401(k)s, IRAs, and other defined-contribution retirement programs tend to have equity allocations. A household may even be indirectly exposed to the stock market in defined-benefit pension plans tied to final salaries, as the provider of pensions (the employer) might be invested in stocks.”
Many households are also falling far short of the savings rates needed to fund their retirement. The Center for American Progress estimates that almost 70% of near-retirement households are at risk of not having enough money saved for retirement. Unfortunately for those somewhat further away from retirement, being saddled with $1.4 trillion in aggregate student debt isn’t a great start, especially when one factors in stagnant wage growth and rising rents.
Maybe it’s time the 2 and 20 “smart money” crowd gave mom and pop some AUM to manage: that way the former can finally “outperform” a benchmark, while the latter could actually have money for retirement.