Securities are theoretically supposed to be highly liquid due to the fact the stock market is  a meeting place of buyers and sellers. However, some publicly traded securities simply cannot be moved quickly. One such situation happened during the credit crisis when it is difficult to sell stocks in certain companies. More commonly, stocks can become illiquid simply because there’s not enough daily trading.

Take, for example, the growing selection of dividend ETFs. Each has their own unique features. Picking one goes beyond the weighting of the ETF or their MER. Look at the trading volume of the following dividend ETFs as of November 15, 2011.

XDV-T: 52,719

CDZ-T: 56,752

XEI-T: 8, 234

ZDV-T- 1,200

PDC-T: 6,100

What is interesting to note is that ZDV-T, BMO’s Canadian Dividend ETF, has the lowest MER and arguably the greatest distribution reach as a bank issued product. However, the daily trading volumes are not sufficient for an investor to buy or sell the product. By only looking at MER, an investor may not be aware of the fact that they may own a product that is difficult to sell.

The lesson being the  lowest fees are not always the end all and be all in looking at ETFs.

One side effect of a liquidity trap is that money which is easy to come by for those who can raise it (banks and big publicly traded companies come to mind) are not spending it. The result is these entities have literally billions of dollars in cash which is not being invested since the economy is not sending clear signals it is stable or expanding.

But is this necessarily a bad thing? A University of Lethbridge study entitled “Down Markets and the Excess Cash Theory of Dividends” argues that companies with excess cash in intense to mild down markets lose greater value relative to those companies without excess cash. However, the decline in value of companies with excess cash can be mitigated by the existence of a dividend policy.

Studies show that dividend-paying stocks outperform non-dividend paying stocks in down markets. This seems to confirm the academic view that investors are attracted to dividend paying stock since it signals the future value of the company or reduces agency costs (although it is noted that the signally theory of dividend is constantly under dispute among academic circles). Furthermore, such out-performance continues in months in which dividends are not paid, suggesting that a share repurchase program would do little to increase the confidence of the market.

What does this mean?

One possible implication is that technology companies holding excess cash (think Apple and Google) are beginning to sow the seeds of their own demise. Without the paying of dividends or a stock repurchase (even understanding its limited effect), the market may soon turn against these market darlings relative to their plucky upstarts. Without more capital or r & d investment, are these tech companies allowing competitors to catch up?

Another implication, if we equate businesses with household finance, is that, over the medium to long term, holding excess cash is not good for any household and that such excess cash should be deployed for revenue generating activities.  It is often an overlooked investment but households should look at how to increase human capital through retraining or acquisition of new skills. Since increasing human capital has long-term effects and is portable, it should be considered a vital part of any revenue generating activity.

After my Dad retired, I came to the conclusion that, in his particular context, a laser-like focus on dividend yield is not necessarily a bad thing for someone with a shorter investing horizon than me (and let’s throw out extreme dividend yields and talk about reasonable yields of 3%-7%).

Let’s recall that dividend yield is calculated as (dividend paid per annum/share price). A higher dividend yield then is a reflection of either a high dividend paid relative to share price or a modest dividend of a company with modest to low growth prospects since share price is a reflection of future earning’s potential.

Conversely, a low dividend yield may not be necessarily reflect a low dividend paid (which can be true) but the stock price being high due to potential appreciation in the company’s value.

In an ideal world, if you have a short investing horizon, all things being equal, stock price appreciation is nice but you want the safe and secure bet of a return based on dividend yield.

Does one with a short investing horizon care about dividend payout ratios? Of course one does to the extent the payout ratio is not so high as to make dividend yield unsustainable. (again, let’s assume we are not talking in the extremes). One has to remember that dividend payout ratios also factor into a company’s growth prospects going forward. The higher the ratio, the more cash is devoted to paying back shareholders at the expense of capital to grow the company.

In the context of an investor with a short investing horizon, does a dividend payout ratio of 60% really matter from a payout ratio of 70%, dividend yields being equal? Most likely not as important as someone with much longer investing horizons since the higher the dividend payout ratio, the more likely growth (both earnings and dividend) will be slowed by the decision of management to reward shareholders over reinvestment.

Investors with long investing horizons may not ideally want a short term focus at the expense of long term growth but the investor with shorter horizons may simply want the money now without the patience to wait for a 5 year growth plan used with capital which otherwise could be paid to shareholders to come to fruition.

The point is that dividend yield and dividend payout ratios are like two ends of a balance scale. For investors with shorter investing horizons there may be more weight put on the yield side at the expense of the payout ratio side while the inverse is true for investors with longer investing horizons.

To paraphrase a blogger (who’s name escapes me otherwise I would attribute it to them), personal finance is 90% personal and 10% finance. Which metric one places more weight on in analyzing dividend paying stocks will be, in part, a function of context.

What has followed since 1961 is a large volume of work concluding there are certainly factors influencing how a dividend policy is established (earnings, free cash flow, tax policy). But, the relevance or weighting of each of the factors is under dispute (here is a recent piece describing succinctly some of the competing dividend research).

This is all enough to make one’s head spin. How does anyone predict a dividend increase?

There is one unscientific approach to looking at this issue. Business is often a race to second. In highly competitive and mature dividend paying industries, dividend payout policies tend to mirror the competitors. The differentiation between competitors is of such a small degree that a movement in dividend by one member of the industry could trigger similar upward movement by its competitors lest the market park its money to the higher dividend paying company.

For example, most of the major Canadian banks have a recent dividend payout ratio range of approximately 35%-45% (in other words, it is paying 35%-45% of profits out as dividends). When the Bank of Nova Scotia recently announced it was increasing its target dividend ratio to 40%-50%, the market took this to mean that its peers would not be too far behind.

(As an aside, a financial institution increasing its dividend payout targets is a good news/ bad news proposition. The good news is obvious. The bad news is that by putting more money into the shareholder’s pocket, the bank may be signaling future growth is slowing and share value should be more reliant on dividend increases than earnings growth).

Similarly, look at the pipeline business. Enbridge and Transcanada both have historical dividend payout ratios in the 60%-70% range. Recent rumblings indicate Enbridge may be moving towards the higher end of this range. Transcanada may follow soon.

The opportunity taking typically occurs where one member of a mature industry has a dividend payout ratio below its peers. For example, Rogers Communication dividend payout ratio of 38% is well below its peers of Shaw, Telus and Bell which sit in the 60-75% range. Rogers has not indicated that it will increase its dividend payout ratio but its low payout ratio sticks out like a sore thumb. This is rectified by either growing significantly faster than its peers (difficult in this market) or increasing its dividends.

Comparing dividend payout ratios among peers in a mature industry is by no means a scientific means to gauge if a possible dividend increase is coming; this theory tends to work best in tightly controlled and oligarchic business environments (hello Canada!). What it does speak to, however, is business’ needs to keep up with the Jones.

The alternative to shifting a portfolio from equity to bonds is to shift from pure appreciation play equities (think tech stocks, gold and mining stocks) to blue chip dividend paying funds.  In the absence of any contextual factors, would a dividend yielding stock outperform bonds?

Let’s exclude government issued bonds (i.e. treasuries) from the equation given their yield is so low and concentrate on the favor of the year, the corporate bonds (whether high yield or, um, not high yield) versus dividend stocks.

In a head to head comparison, the yields are as follows:

Average corporate bond yield as of August 31, 2010: 3.8% (source: Bloomberg)
Dividend yield of the S & P 500 for 2009: 2.0% (it sat at 1.85% as of last Friday)
Dividend yield of the S&P High Yield Dividend Aristocrats Index (50 top dividend yielding stocks traded on the S & P 500): 3.7% (ETF’s which track this index lose some yield due to tracking errors; see this fund which tracks the high yield dividend aristocrats for example)

The nominal return of corporate bonds then is greater than the dividend yield of the S & P 500 or the high yield dividend aristocrats. However, the story does not end there.

You have to factor in the effect of taxes on return. Interest income is taxed at a federal marginal tax rate in the U.S. starting at 25% for anyone making over $33,951 to 35% for anyone making over $372,951 (I excluded the tax rate for anyone making under $33,951 and have forgone state and municipal taxes from this equation for simplicity’s sake). The dividend tax rate in the U.S. is 15% for a qualified dividends (for now; no one knows what is happening after 2010 when the 2003 tax cuts expire).

In Canada, interest income is also taxed at the federal marginal tax rate from 15% up to income of $40,790 to 29% for income over $127,061 (again, excluding the provincial taxes which, in some provinces, pushes the top marginal tax rate into the 40′s%). The federal portion of the eligible dividend tax rate does not exceed 15.88%.

The tax difference between interest from corporate bonds and dividends from stock is most profoundly felt as you move up the income tax bracket. The higher yield of corporate bonds over dividend stocks is, in some circumstances, only on a pre-tax basis.  In fact, under the current tax system, there is a strong argument that the higher your tax bracket, the more tax advantageous it is to be weighted towards dividend yield stocks over corporate bonds all things being equaled.

The tax disincentive of corporate bond is mitigated to a large extent by purchasing these products in tax deferred accounts. However, this fails to consider the other part of the equation- dividend yield stocks have consistently outperformed non-dividend yielding stocks. It is the possibility of lost appreciation, especially for an investor who has a long investing horizon, which makes opting too heavily for corporate bond in lieu of dividends problematic.

Having said all of that, investing is not an either or proposition. A shrewd investor should have both corporate bonds and dividend stocks in their portfolio.  For most investors, it becomes a question of portfolio weighting of the two products. If nothing else, this post should at least draw one’s attention again on the effect of taxes on returns. Good luck.

(some of you may have noticed that the look and feel of the blog has changed. This is temporary. My WordPress template crashed last week. A new format will installed soon.)

But, if you believe in the dividend signaling theory, could the act of declaring dividends itself act as a signal for decreased volatility in a stock? There appears to be evidence indicating as such.

A 1989 research paper found that after a company began declaring dividends, its stock price experienced lower price movements after earnings release and price variability falls after the initiation of a dividend policy. The conclusion being that investors tend to look at the dividend policy as a signal or bellweather to the future much more than earnings itself. Certainly, this would be reflected in the greater price effects of a dividend paying stock increasing or decreasing its dividend than merely meeting earnings expectations.

There is, admittedly, self-selection in the process; dividend stocks tends to attract certain types of investors who place a relatively larger premium on the cash flow component of the stock than pure momentum traders/investors.  This raises the larger question of whether it is wise to purchase a dividend paying stock purely on the dividend increase itself rather than the underlying fundamentals. However, very few of us are purely rational beings in the market.

Not surprisingly, where dividends cease to be paid, two inter-related results arise. Without a dividend policy, earnings variance increases and earnings predictability decreases.  This is explainable in that earnings and cash flow have to be predictable to declare dividends in the first place; dividends tend to be revoked once you lose that predictable cash flow (see banks in 2008 and 2009) which effects earnings expectations as well. Without any consistency in earnings, companies are more likely to meet earnings expectations and be punished by the markets.

The conclusion seems to be that investors with low tolerance for volatility and a desire for some type of predictability, but require an exposure to equities, should gravitate towards dividend paying stocks.

In 2007, the 5 largest American financial services stocks (JP Morgan, Wells Fargo, US Bancorp, Bank of America and Citigroup) represented 14 cents of every dollar paid in dividend by the S & P 500. In 2010, these same 5 stocks are on track to pay only 2 cents of every dollar in dividend.

Many believe that the banks will not be increasing their dividend soon. All of this bad news raises the question of whether it is time to reassess how many bank stocks should be in a dividend portfolio.

Let’s start with the simple question- are the good times over for banks increasing dividends? The short answer may be yes.

S & P has stated that the historical dividend growth rates is 5.6% per annum. From the period of 1995 to 2008, the smallest percentage dividend increase by Wells Fargo was 7.6% with 7 annual double digit percentage increases. Similar results can be found for each of Wells Fargo’s counterparts.  In other words, banks displayed historically anomalous dividend increase behavior in the last 15 years which can be replicated if the same economic conditions exist.

If you assume that banks will revert back to the norm with respectable 5.6% ish annual dividend increases, it stands to reason that investors, such as myself, have no real reason to be overweight in banks especially since dividend increases for some banks are really recovery of dividend cuts of the past several years.

If you assume the opposite, that banks will eventually regain their shine, the events of 2008-2009 indicate that such rewards come with proportionate down side risk; these are not your grandma’s bank stocks and regulatory freedom gave the banks the rope to succeed and eventually hang themselves as well. Given such risk/reward, should an investor with a less than steely resolve, and a strong stomach for watching paper losses, be overweight in this industry?

Regardless of whatever assumption one believes, since diversification is the only free lunch in investing, what should be the proper weighting of banks? There is no definitive answer other than what is NOT the correct answer for most investors.

A portfolio consisting of over 50% in banks stocks would be overweight. Money could invested in industries which work counter-cyclical to bank stocks (consumer staples) or may be more stable dividend payers (utilities which is regulated on pricing supporting, and capping, earnings).

The question, which I do not have an answer to, is whether one counts bank issued preference shares in determining the percentage of bank stocks in an asset allocation. In a near worst case scenario, a bank could suspend its dividend payments but continue to pay its preference shareholders. But the yield on preference shares is partially a function of the balance sheet health of a bank. Any thoughts are appreciated.

A weighting of under 10% may probably be too low for many average investors, keeping in mind that bank stocks tend to lead both Wall Street and Main Street recoveries and, once upon a time, they were actually safe stocks. If we return to a pre 1991-2008 normal, they may soon be again.

I would suggest as a model dividend portfolio something analogous to Nurse911’s dividend portfolio in terms of sector diversification and mixture of growth/mature stocks. As you can see, his dividend portfolio has a goldilocks exposure to financials- not too hot and not too cold.

Finally, there is a geographic drifting towards bank stocks one has to be aware of. The U.S. S & P Dividend Aristocrats has only a 7% weight in financials. The Canadian counterpart has approximately 39%.  In other words, purchase a dividend ETF tracking the Canadian S & P Dividend Aristocrats will naturally give you a large exposure to bank stocks.

This gap is partially explained by the poor results of the American banks versus their Canadian counterparts and partially by the fact the Canadian stock markets are basically compromised of financial stocks and commodity stocks (which suggests buying a board based Canadian equities ETF in tandem with a Canadian dividend ETF is substantially an exercise in redundancy). Thus, an overweight position in bank stocks may be a function of geography and there should be a greater focus by Canadian investors to ensure they are not drifting into an overweight in bank stocks.

As we settle into a year of the unknown, what warning signs should dividend and income trust investors look for to determine if a dividend paying stock or income trust may be going down the wrong path. The following are 3 real life examples:

Moving away from organic growth to new business lines. Kingsway Financial Services is a mid-cap company which became successful providing insurance to higher risk drivers and truckers. At its very peak, it was paying a 7.5 cent dividend per share a quarter; a respectable dividend for a mid-cap stock. However, in many respects, its success sowed the seeds of its own destruction.

Flush with confidence, it started a rapid expansion into the United States, a market which it had little experience in, and into other business lines (it bought a hurricane insurance company at one point which stretches the concept of synergies). The company, at its peak, had 9 operating units- quite a lot for a mid-sized company. Then, the bottom fell out.

The company’s downfall was partly due to declining economic conditions and partly due to bad underwriting. Underwriting mistakes, which means you underestimated the risk of loss, often happens if a new entrant under-prices itself to gain market share or does not understand the business well.

In 2008, it began to divest of assets. So much so, it gave away the shares of one of its subsidiary to a charity to avoid taxes (this transaction is now under investigation). The stock traded in the mid-teens five years ago. It now trades for less than $2 and it pays no dividend.

Kingsway is a good example of how empire building can destroy shareholder value.  Investors want dividend growth but one has to be careful how a business is pursuing this growth. If the company begins moving away from its niche, it can be seen as a warning sign. Kingsway is but a recent example. TransCanada’s dividend cut of 1999 was the end result of a business moving out of its core competence to empire building. The silver lining for TransCanada was it had a significant economic moat in its main business line to recover from this error.

The company is over-generous in its pay-out policies. This warning sign is unfolding as we speak to Riocan REIT.  Many have wondered whether Riocan was overly generous in its distribution policies during good times. In particular, its distribution policies seemed to be premised on the assumption that profits from the sale of properties would supplement regular rental income.

This led to the unusual situation of Riocan’s occupancy rate increasing in 2008 and 2009 but increasingly distributing more than it brought in; the lesson being fluctuations in earnings, especially premised on big transactions, coupled with high payouts can be warnings signs to dividend investors.

According to Riocan’s financial statements, for fiscal 2008, it paid out 102.9% of adjusted funds from operation (adjusted funds from operations, or AFFO, is a non-GAAP measure that is a “true” measure of cash flow in a real estate concern). For fiscal 2009, it paid out 127.2% of AFFO or it took in $1.00 and paid out $1.27.2.

This situation is mitigated somewhat by the fact Riocan offers a dividend reinvestment program which allows the company to pay distributions in shares rather than cash. The result is that in 2009 it took in $1.00 and paid out $1.04.5 in cash and the remainder in shares.

One wonders how much longer this situation can be sustained. Alternatively, economic prospects brighten and the increase in cash flow puts the company at a cash flow even position. In this situation, does management push the company back to an unsustainable payout betting on a long term recovery? Cautious investors would probably say no and want to pay it safe.

The lesson being watch out for a company that pays out dividends and income trust distributions generously as a means to entice new investors. It could be building a house of cards that may fall in bad times.

A change in management philosophy. Too much debt is the enemy of the dividend investor. Lenders can force dividend paying companies to slash its dividends through covenants found in loan agreements or, more subtly, force companies to slash dividends as a condition of maintaining credit facilities.

As we work our way through the recovery, a dividend investor in a high debt company may face a double whammy. A difficult re-financing market for some industries may force the company to free up cash by slashing the dividend or there may be a change in philosophy about risk tolerance levels.

Manulife Financial is perhaps one of the more (in)famous example of a change in management philosophies about risk and debt. Under a CEO that attracted a lot of press, a company which managed risk for a living began to take risks itself. In the beginning, such risk taking was rewarded by the market and earnings translated to increased dividend payments to investors. However, the risk taking lead to the company incurring  large annuity related obligations it will have to pay in the future-with the underlying assets to pay for such obligations reliant on the performance of the market (some of this exposure is unhedged).

The CEO who oversaw the creation of this situation had a much more liberal view of assuming debt than his successor and some believe that he was more interested in creating an asset management company than operating an insurance concern (see my first point above). The new CEO slashed the dividend- twice- in order to give the company financial flexibility and appears to have a very conservative view of incurring any new liabilities.

This factor bears special attention since the super star CEO who thought he was an i-banker may be giving way to more custodial type management. American banks notwithstanding, the accountants and operational people seem to be taking over from the deal making CEO’s (see Walmart, Rogers, CN).

The lesson being be careful of the company that increased dividends by taking greater than normal risks. It some point, its corporate culture may kick back in and revert back to its more conservative ways at the cost of the dividend.

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None of these factors alone spell trouble for a dividend paying company but they should be warning signs and signal to an alert investor to keep a close eye on the situation.

The act of conversion alone is not to blame for such a large distribution cut. Revenue and earning decreases in a down economy have only poured salt into the wound of income trust investors. As the drop dead date for the new tax regime looms, will increased income trust conversions lead to yield chasing by investors seeking alternatives?

Income trusts typically have higher yields than conventional stocks. For example, the long term adjusted funds from operations (AFFO) yield for REITS is historically at 8.1% (AFFO is considered a truer measure of a REITs cash flow). If investors, weaned on high income trust yields, decide to substitute income trusts for alternatives, will their baseline analysis be to other high yield products?

One hopes not for several reasons. As many commentators have noted, dividend growth is more attractive than dividend yield.  Dividend yield is calculated as annual dividend paid per share/price per share. Thus, high yields are a function of high dividend payments, low share price or a combination of both which means the company has little room to pay out more or the expectations of growth are limited. This may not be a large factor for someone with a short investing horizon but it is important for long term investors who can increase returns by receiving constant dividend increases.

The other issue is what are the substitutes? The natural substitute is to move to a REIT (generally exempt from the new tax regime) but REITs are not value plays (at least in Canada; on the income side, Canadian REITs are paying out 94% of AFFO meaning do not expect large distribution increases) or are facing some serious short-term issues (American REITs suffering from increased vacancies and refinancing concerns where the asset already possesses a high loan to value ratio with the value continuing to erode).

The other natural substitute, dividend paying financial stocks, also have their well publicized issues. When JPMorgan Chase announced that its loan loss provisions in the last quarter have not significantly declined, it confirmed what many suspected. The banks are a long way out of the woods yet.

This is not to suggest that pursuing a high yield substitute is, in and of itself, a wrong strategy to pursue; for example, heavily regulated utilities tend to have high yields and some margin of safety given electricity is a necessity. However, a dogmatic chasing of yields could lead to trouble. The prudent approach is to find a balance between yield and growth and to wait out a large movement of cash out of converting income trusts to other high yield products.

What then are realistic expectations of return on stocks and real estate?

STOCKS

Jeremy Siegel notes that total nominal return (return before inflation) for stocks from the period of 1802-2006 was 8.3%. What we witnessed from 1985-2006, where nominal return was 12.4%, was a historical anomaly. To use an often-quoted phrase of 2010, the “new normal” should be a reversion to historical mean.

However, one never uses the past to predict the near future. To realistically predict future expectation of growth, one uses the Gordon Equation which is (dividend yield + dividend growth rate). The S & P 500 dividend yield was 2.0% in 2009. It has been predicted that the S & P 500 dividend growth rate will be 6.1% in 2010 (according to Business Week, the historical dividend growth rate is 5.56%) . In other words, the “experts” predict expected equity return of 8.1% which falls within the historical range.

Practically speaking, and let’s assume high single digit growth does come true, subtracting inflation and transaction costs, a realistic real return for most retail investors should be in the range of 5-7% if one tracked a broad based index; aim for this sweet spot and one has a reasonable expectation of return without subjecting oneself to above average risk.

Any investment that is advertised to yield greater than this  range requires a greater risk tolerance on the investor. Thus, anyone pitching an investor a product returning 10-15% this year is not lying but is implicitly asking the investor to undertake a large amount of risk. The question is not whether the 10-15% return is realistic but whether one has the stomach to suffer loss in the event the manager reaches too far to attempt to produce such return.

Remember one of the key rules of investing: never invest any money you cannot afford to lose.

REAL ESTATE

Admittedly, since all real estate is local, the following is a broad based review and not an indication of local conditions.

Appreciation

To quote William Bernstein:

“..the best data on house price suggests that after taking inflation into account, the answer [to how much a house appreciates] is slim to none. These data focuses on historical data from three nations.  Real house prices (TMW- in other words after inflation return) in the United States did not rise at all between 1890-1990…Thus, at most you will receive a 3 per cent real (1 per cent price increase plus 2 percent net ‘dividend’) return on your home …”

The study Bernstein cites on real returns from 1890-1990 is a 2006 piece by Robert Shiller. Shiller, as many of you know, was one of the more famous economists who called the housing bubble before it burst.

Income  from real estate

The standard way to measure return on real estate is to determine the capitalization rate or cap rate. A cap rate measures expected asset level return. It is calculated by: annual net operating income/cost.  For example, a rental property nets $10,000 of rental income on a $100,000 purchase. Thus, the cap rate is 10%. There are downsides to using cap rate to determine return but it is generally viewed as a standardized measure of income production from real estate.

It is difficult to determine cap rates for smaller rental properties or non-institutional real estate investors. Collection of data would be difficult given the hundreds of thousands of real estate investors who would have to give honest feedback to someone.  However, data is much more readily available for institutional based commercial real estate. To this end, the National Council of Real Estate Investment Fiduciaries states that historical commercial real estate cap rates is approximately 7.6%.

Cap rates for most retail real estate investors may be lower than 7.6%. Most commercial leases work on what is known as a triple net basis. In plain English, the tenant has to pay for all of its proportionate costs of the leased premise including taxes, operating costs/maintenance and insurance. Most commercial leases  grant the landlord the right to adjust these costs retroactively if their estimates were off.

Smaller real estate investors, especially operating in rent control regulatory regimes, are granted no such right to full recovery (not to mention the opportunity costs of tending to the property which commercial landlords hire managers to carry out). Accordingly, small scale real estate investing may have a cap rate lower than 7.6% analogous to stock return being eroded by transaction costs.

If we assume that there is some slippage between institutional and non-institutional real estate investors, one is left with a cap rate within the range of 5-7%.

WHAT DOES THIS MEAN TO YOU?

The above suggests that “magic beans” promising returns of double digits over the medium to long term is accompanied with higher than average risk tolerance. If one cannot stomach such risk, then Jack- he of a long investing horizon and no assets to lose- may be better off buying the beans instead.

What strikes me about the data is how unrealistic investors became about expectations of return over the last 10-15 years. A real return of 4-6% in the stock market or in real estate investing is nothing to sneeze at (consider that most non-managerial salaried employees receive raises of 3-5% in good times which is really a 1-2% raise after inflation; this tends to suggest prudent investing yield greater year over year return than human capital). Perhaps there is nothing wrong with the stock market or real estate market. There may be, instead, something wrong with our expectations.

It is interesting to note that nominal return on stocks and real estate are similar; if you add in the 1% appreciation plus the 7.6% cap rate, you end up at 8.6% nominal real estate return vs. 8.3% nominal return on stocks.

What it suggests is that, in a vacuum, opportunity costs between the two assets classes is not material different. However, what Bernstein overlooks is that real estate appreciation, small as it is on a global basis, is tax-free in many jurisdictions as it pertains to the principal residence.

There may be a greater tax effect on stock sales depending on what jurisdiction you live in (some jurisdictions outside North America have no capital gains tax on stock sales).  Stock investing is a “passive” compared to real estate investing. This raises the question of whether the government tax policy on real estate is a recognition that sweat equity has been contributed which should be rewarded with better tax incentives.

To go back to my initial point, the above are average expectations of return based on historical data. There are obviously local effects and greater or lesser than average returns in short-term transactions. But again, the question is not whether one wants higher returns- we all do- but  does one have the risk tolerance to pursue such returns?