September 25, 2022

The curse of the screen / Financial assets vs real estate / A simple example with rising interest rates 

Financial assets have  some great advantages like the ability to diversify and the possibility to engage in partial sales to finance desired expenses. No doubt, Liquidity is a great blessing.

However, they also have a great disadvantage . They create nervousness as a result of their ability to provide continuous valuation. Investors sometimes panic by marking the portfolio to market and by observing the lower valuations. In contrast, they are much calmer, patient and thus more efficient with real estate or the value of their business as they do not panic from continuously monitoring their values.

A simple example with real estate provides this contrast.

If interest rates rise and the required return from the asset goes from 4 pct to 5 pct, the real estate asset will  have to decrease in value from 1mio to 800k in order to create the same income stream of 40k.  The assumption here is that economic conditions do not allow rental income to  increase in an analogous way to the increase in interest rates.

Higher Mortgage rates will  contribute to the adjustment in value by reducing demand.In addition, another negative factor will be the increased cost of borrowing for construction . 

However, investors in most cases investors do not  panic from  these developments as they do not engage in continuous valuations and are not so worried by the the depreciation of their real asset  !

Behavioral economists recommend that in order to avoid stress  to stop watching  the liquid portfolio during market drops  unless a trade is absolutely desired . Indeed, the game of Greed and Fear can become very dangerous with continuous pricing . It can lead to great discomfort, emotional sales and the realization of losses that might prove regrettable very soon !

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