Two dangerous financial myths busted

The extent to which we human beings have great big blind spots never ceases to amaze me. Some of these are fundamentally amusing, but many such blind spots are actually properly harmful to our health and happiness.

As Mark Twain allegedly said: "It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so."

In my experience, this phenomenon is particularly prevalent when it comes to finance, given how neglected a life skill financial literacy is and given how many so called "cognitive biases" we suffer when we think about things financial.

Four phrases that I hear time and time again in various different shapes and forms are: "you can't go wrong with bricks and mortar"; "rent is throwing money away"; "cash is king"; "the stockmarket is risky".

At a basic level, these statements are simply misleading. I would go further, however, and suggest that they are all fundamentally incorrect and downright harmful to individuals and to society as a whole as a result.

The fact that so many people trot them out as accepted "fact" is often ruinous to their financial situation and, by extension, their life more generally.

You can go wrong with bricks and mortar

Just like every other asset class, property prices go up and down. They also go sideways. From 1900 to 1965, UK property prices hardly budged.

For much of the world, the explosion in nominal property prices since then has far more to do with what has been going on with the global monetary system than with any fundamental increase in the value of property.

Failure to understand why this is may well get lots of people in financial hot water in the relatively near future.

Property is one of the least liquid asset classes out there, meaning that it can take a horribly long time to buy or sell.

In addition, it suffers from the most significant transaction costs of any asset class - especially in the UK with stamp duty being where it is now and more property taxes very possibly on the way in the years ahead (an annual value tax similar to what many US states charge seems more and more likely given how the makeup of the UK electorate is changing).

Property is also an asset class that most people can borrow large amounts of money to purchase - even people who don't understand what things like "rental yield" or "opportunity cost" mean.

Borrowing money to buy something which then falls in value because it was structurally too expensive is a recipe for going very wrong indeed financially. The fact that this hasn't happened much in recent years does not mean it won't happen in future.

This is "recency bias" at work (believing that because something has been a certain way in recent years, it will always be that way).

The whole 'rent is throwing away money' thing

Recent figures for the prime central London borough of Kensington and Chelsea suggest that prices are down at least 10%. On a £1 million property, even a 10% fall means the price is down £100,000. That is a lot of rent.

Rental yields in this area of London are about 3-4%, implying you could rent that house for about £30,000-£40,000 a year.

Someone in the market for that property a year ago who decided to rent and wait a while would be as much as £70,000 ahead by now - roughly three times the average British salary - but this doesn't account for the £100,000 they would have paid in stamp duty and other transaction costs (surveyors, solicitors and estate agent fees when they come to sell).

In reality the renter would be nearly £200,000 ahead.

A 20% fall would imply they'd saved themselves more than £300,000 - that is a decade of renting (and being able to move at the drop of a hat if desired). This isn't science fiction. This is precisely what is going on in London right now and I think there is a great deal more to come.

People say you "can't time the market". I would say that you really can, if only by considering prevailing rental yields. If they're 3-4%, it is quite possibly time to rent. If they're more like 6% or even more, it's probably time to buy (all other things being equal).

You won't get it 100% right and there is obviously the significant additional emotional benefit that so many people get from home ownership (then again, I think there is a significant emotional benefit in the flexibility renting can give you).

But thinking along these lines will at the very least maximise your chance of avoiding the personal calamity of negative equity that so many people endure when corrections happen.

Andrew Craig is founder of Plain English Finance and author of How to Own the World.

This article was originally published by our sister magazine Money Observer here

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.