There has been a great deal of discussion, in the media and through email correspondence, over the residential property versus sharemarket issue.

A number of individuals have accused this column, and other business commentators, of being anti-housing and promoting their own interests, which is the sharemarket and other financial assets, by attacking residential property investment.

Many individuals have also stated that they would never invest in the sharemarket because of our hopeless regulation, poor governance, related party transactions and other one-sided deals that place the interests of major shareholders ahead of smaller ones.

The housing versus shares issue is extremely important and deserves another look from both an individual and a national point of view.

This column is not anti-housing but it does believe that investors should have diversified portfolios and shouldn’t have all their eggs in one basket.

All investments are risky and it is imprudent to have all one’s investments in either the sharemarket or finance companies or, for that matter, gold or farms or residential property or any other asset.

A large percentage of investors believe that residential property is a sure winner and they are borrowing heavily to invest in this asset class.

That has been a good decision in recent years as the total value of New Zealand residential property has risen from just $81 billion in December 1986 to $568 billion in 2008 while the value of the domestic sharemarket has been static at $42 billion over the same period (see table).

However Kiwis now have one-sided investment portfolios with housing representing 75 per cent of gross assets, compared with 54 per cent in 1986 and 99 per cent of net assets, after borrowings are taken into account, compared with 61 per cent in 1986.

Our housing to individual wealth ratio is the highest in the world.

This column is not forecasting a housing market downturn but it is important to remember that past performance is not always a reliable indicator of future performance.

It is hard to believe now that New Zealanders were completely besotted by the sharemarket in the 1980s just as they are with housing today. Newspapers were full of comments from sharemarket experts who recommended companies and industry sectors. These days, the media is obsessed with the best time to re-enter the housing market and which suburbs offer the best prospects.

Stockbrokers who recommended that investors reduce their holdings in Chase, Equiticorp and Rainbow in the 1980s were ridiculed when share prices rose another 10 per cent after they sold.

Commercial property was incredibly hot, with over 50 listed companies operating in this sector, as investors believed that CBD land was in short supply and property was a sure winner. Most of these listed property companies went bust after the 1987 sharemarket crash.

The problem with the 1980s was not that individuals invested in the sharemarket, it was that they borrowed too much and invested too much in shares. This inflated share prices well beyond fundamental values. One of the problems with the finance companies was that individuals lent too much money to these companies, particularly the property related ones, and they ended up funding riskier and riskier developments in order to use this money.

The huge amount of money that has flooded into the housing market has pushed up prices and New Zealand residential property is now severely unaffordable, according to the latest Annual Demographia International Housing Affordability Survey.

The survey covers 265 cities in Australia, Canada, Ireland, New Zealand, United Kingdom and United States and all seven New Zealand cities are in the worst 22 per cent in terms of housing affordability.

According to Demographia, Auckland is ranked 239 out of 265 cities.

It is imprudent for individuals to have almost all their investments in residential property, particularly after the asset classes’ strong performance in recent years, its high unaffordability rating, the country’s huge household debt levels and the prospect that the Government may take action to dampen this market.

There are negative implications for the economy if a huge amount of resources are channelled into any one area at the expense of others and if the dominant area is substantially funded through offshore borrowing.

There is no doubt that the household borrowings are crowding out other borrowers, as household debt represented just 30 per cent of total bank lending in June 1990, the earliest available figure, compared with 51 per cent at the end of 2008.

The banks have lent aggressively to the household sector for a number of reasons, including the ability to secure this against residential property, bank capital adequacy requirements that have a bias towards mortgage lending and politicians who are unwilling to do anything about the over-allocation of resources into residential property.

The other problem is that households had bank borrowings of $162 billion at the end of 2008 (the figure in the table is total household debt from all sources) but had bank deposits of $87 billion. Thus, a large percentage of this $75 billion deficit is sourced by the banks from overseas.

From an economic point of view this makes no sense, as illustrated by the following example.

An individual buys a house for $400,000, with 80 per cent bank borrowing mainly funded from offshore, and sells it five years later for $600,000 without making any improvements. As the buyer also has 80 per cent bank borrowing, mainly sourced from offshore, the country’s overseas debt increases by a net $160,000 as a result of the second transaction.

This places a drain on the economy in terms of additional offshore interest payments, pushing up house prices for new home buyers and creating no additional economic activity except for the real estate agent.

Rising house prices are acceptable if they are consistent with the overall performance of the economy and most of the borrowings are sourced from domestic savings. Strong residential property markets can cause major distortions, and problems, for an economy if too many resources are poured into this area and it is substantially supported by offshore borrowings.

Finally, there is the issue of where do individuals invest if they don’t go into residential property and this question is not easy to answer.

New Zealand experienced a dramatic market failure during the sharemarket boom of the 1980s and after the crash a number of inquiries recommended a substantial overhaul of the regulatory regime governing capital markets.

These proposals were successfully opposed by a number of influential businessmen, mainly through the Business Roundtable, who strongly advocated that retail investors were free loaders who were not entitled to a protective regulatory regime.

Since then, individual investors have turned their backs on financial markets, as reflected by the tiny size of our sharemarket.

Those who stayed have had a heap of rubbish hoisted on them, including Blue Chip, Credit Sails, ING yield funds, First Step, Feltex, a host of finance companies that were little more than personal banks for their major shareholders and other dubious investments.

The recommendations of the Capital Markets Taskforce, which is due to report before the end of the year, will have a major influence on whether New Zealanders will reduce their exposure to residential housing and have a more balanced investment portfolio. I will look at the role of the taskforce in more detail next week.