Imagine a client coming into your office full of anxiety. He has all his money tied up in a big, risky investment that has done very well for him in the last seven years, consistently yielding 20 per cent a year. In the last five years, the investment has done particularly well, doubling in value.
However, he knows from reading the newspapers that his type of investment is quite capable of falling in value. Economists are saying that this particular asset is now 30 per cent overvalued when viewed against historic trends. Experts are consistently saying there is no way his investment can maintain its value.
He is quite anxious as, should his investment fall in value, it could cause a major upset to his financial plans. This is effectively the only investment he has and he is looking for some way to crystallise his gains.
He wants to switch his money into an investment where he can be sure what he has gained will not be lost.
The obvious advice would be to sell it and take cash. If I were in the shoes of a financial adviser, however, I would take great care to make it clear in the reasons why letter (or its new equivalent) exactly what his views on the outlook for his investment were. After all, if you advised him to sell and his asset went up in price, he might be annoyed with you. In the other hand, if it went down, he would be most grateful.
With a unit trust, an investment trust or a FTSE tracker fund, this would be simple. But what if we were talking about his house?
At this point in the conversation, there is usually a fundamental objection. How can you compare decisions about a house to decisions about investment trusts? Investment trusts may make you money but they do not keep you dry and warm. You do not have to live in one and, unless there is something wrong with you, you rarely feel the same emotional attachment to your investment trust as you would towards your house.
But one of the fundamental changes of the last 20 years – the reason we are interested in house prices in the first place – is because we have come to see it as an investment. The Thatcherite expansion of home ownership had exactly that sentiment as its corollary. Not just “you too can own a home” but “you too can get rich”.
This was supported by numerous anecdotes from people in their 50s and 60s who had made more money on the housing market than in their working lives.
Of course, investments can go down as well as up. Bank of England governor Mervyn King has done his utmost to bring that point home. But are we really taking it seriously? Who out there, among all you astute financial advisers, are teasing out the consequences of a possible house price fall for your clients?
Who among you would seek to say to a client like the one described above: “Yes, sell your house. Give someone else the risk of house prices falling. Take cash as it will hold its value. Rent for now. Maybe, in a few years time, when prices have fallen, you will be in a position to buy somewhere bigger.”?
In many cases, the proceeds of the house sale will be sufficient to generate enough interest income that any difference between the monthly mortgage payment and a higher monthly rent will be wiped out. And rents, with all the buy-to-let activity, are coming down, according to some indicators.
No one has a crystal ball and the market may continue to rise. But if your client took the view of the market described above, would it not make sense to give exactly that advice? Stripped of the emotion associated with home ownership and looking frankly at the purely financial logic, wouldn't someone who took the above view of where the housing market was going be well advised?
The fundamental economic fact that is forgotten about house price rises is that they do not make homeowners better off. In fact, except for special groups, it is the opposite. Anyone who watches prices go up by 10 per cent should remember that, if he or she wants to trade up to a bigger, better home, that price rise makes them worse off. If, for example their house was worth £100,000 and they were looking at buying a place worth £200,000, a general price rise of 10 per cent would push up the value of their own home by £10,000 and the value of the place they were buying by £20,000. As a result, they would be £10,000 worse off.
The only cases in which people are economically better off as a result of rising house prices are where they are planning to trade down to a cheaper property, for example, if the children have left the home and the parents no longer need the space of if they move to another country where prices are not rising as quickly.
If emotions were dictated by logic, it should be easy to tell most clients that when house prices come down, they should not be dismayed but glad. But, of course, they aren't.
Andrew Verity is a financial reporter at the BBC