I've been thinking about debt and asset allocation lately... (as you do ) According to Vanguard's booklet on investment returns ( http://www.vanguard.com.au/library/pdf/Realistic_Expectations.pdf ) Australian shares over the 20 years to June 2006 have returned 11.9%pa on average. Whilst we could slice and dice the figures further to find out large caps vs small caps, which industry sectors did better or worse etc, let's just take it that Australian shares have done 12%pa. Warren Buffett is regarded by many as the world's best investor. His investments have grown at an average rate of 27.6% pa according to www.warrenbuffett.com.au. So we can expect that our returns, assuming we're average or above average will be somewhere between 12%pa - 28% pa over the long term. Certainly quite a range. Let’s say we’re slightly above average and can do 13%pa. How does that compare to direct residential property? According to this Russell report residential property has returned 12.1%pa over the 20 years to 31 December 2005 (ASX Russell Long Term Investing Report 2005) Of course 2006 hasn’t been too kind to the East coast so perhaps we can just call it even and say residential property will do around 12%pa on average. But what about if you’re a below average property investor? What if your properties only grew at say 7%pa or maybe even 6%pa on average over 20 years? Is there a way you could still end up ahead using property rather than shares? The answer is, of course, YES. Through the power of gearing. Gearing will magnify your losses but it also magnifies your returns. On my calculations if you had $200k to invest, borrowed 80% to buy a $1m property and got only 6%pa growth, then assuming interest rates at 7.5% and maintenance/rates at 3% of the property value, then after 10 years your net equity (after paying the interest and costs) would be around $877k. In contrast with ungeared shares where you managed 13%pa (i.e. slightly above average) over 10 years (a record many fund managers would be very happy with) then your equity would be only $679k, over $200k less. Of course, over the next 10 years, assuming the same results the power of compounding starts to clawback the advantage so that in year 20 the property equity is $2.25m and for the ungeared shares it is $2.3m. The ungeared shares over 20 years have it by a nose! But we’re ignoring here the fact that in year 10 perhaps you took your $200k equity and invested it elsewhere (maybe even in shares!) and started earning a return on it as well. Ah, you say, that’s fine but what about geared shares? If you add a 50% margin loan @ 9%pa to the mix things look a lot different. At the 10 year mark the geared shares result in equity of $1.14m well ahead of property geared at 80% with a 6% return. Of course the 20 year result is a massively ahead, with equity at nearly $4.4m! So does that mean the case is closed and geared shares are the way to go? Well, let’s see what happens when you crank up the gearing on the property to say 90%. The result is very interesting. At the 10 year mark we have equity of $1.54m, $400k ahead of our 50% geared shares which had a return of more than twice our below average property. In 20 years’ time, the result geared shares have again won by a nose, with property resulting in equity of only $4.29m. Now of course on day 1 you would have had to pay some lenders mortgage insurance, perhaps $8-10K or more and of course a substantial amount of stamp duty. But over the long term those amounts become inconsequential. What if you really cranked up the gearing on property to say 95%? I’ll let you do your own sums ;-) but you’d need a return of around 16.5% from 50% geared shares to match the outcome over 20 years and your equity only catches up very late in the day. Meaning a lot of lost opportunity cost from not having the equity earlier to deploy in further investments. I might add that if you can do 16.5%pa year in, year out over 20 years you should immediately march up to a large fund manager and demand they give you an 8 figure salary, massive bonuses and a big office with harbour views Of course if you’re the next Buffett and can do 28%pa on ungeared shares for 20 years then you’ll trounce the opposition and make a motza. But bear in mind you’ll only catch up in the equity stakes by year 12… So, apart from having some fun with modelling the future, what can we learn from these projections? A very average property with good leverage can beat a sharemarket expert with less leverage over the long term. Just as we all think we’re above average drivers, most investors think they’re above average when it comes to investment. Of course that cannot be true. So if we assume we’re about average when it comes to investing then when it comes to property, highly leveraged, maybe, just maybe, that’s okay. We can be average when it comes to property selection provided we gear to 80% or more and hold on for the long term. Which I guess is what authors like Jan Somers have been saying all along. To achieve the same results as a pretty ordinary property investor with shares requires above average skills over the long term. So, perhaps the question should be, why are we holding shares/managed funds instead of property? The analysis above would suggest the only correct answers to that would be: a) I’m using it to cashflow my negatively geared properties; and/or b) I’m using it as a saving vehicle to get the deposit for my next property. Perhaps the third acceptable answer is that we’re holding shares/funds to have ready access to some liquid assets rather than holding cash. Ultimately then, the answer to the title of this post is that the REAL story of property vs shares is a story of different permitted levels of leverage. What do you think?