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Wealth destruction: time to revisit those financial plans


As befits our financial planning background, a theme of this blog for several years has been the excessive leveraging of household, corporate and government balance sheets. Economic activity grew faster than incomes and rising asset prices, particularly land prices, created a false impression of wealth (and of collateral for the banks lending the money).

Most permanent wealth destruction is likely to arise from credit exposure. It affects UK private clients through their holdings of banks shares, via dilution of their stake in recovery. Some of this dilution has already occurred but there is worse to come as recession bites, as this new bank capital is itself consumed by bad debts, eventually all but wiping out most original bank shareholders. It will also materialise in private clients’ holdings of corporate bond funds and credit-based hedge funds. For property and equities, permanent wealth destruction arises because recovery is so muted or so slow as to provide no benefit for its owners. Examples are people who need to realise assets to spend in the next, say, 7 to 10 years, such as to meet retirement spending. Structured products may never recover earlier paper gains because there is not enough time. For endebted households, the quick route to permanent loss is forced liquidation of assets but there is also a slow way, via the penal cost of debt service.

The wealth that stands to be recovered, eventually, is land and equities but (as we frequently explain in this blog) it can take up to two decades to recover past excess valuation levels. Remember too that ‘reversion to the mean’ applies to markets and indices but not necessarily to individual companies, many of which will have destroyed investment capital permanently. For those who do not need to sell, property and equity wealth has not been lost forever but the wealth creation we unrealistically expected will probably never be enjoyed. This applies to asset holdings but it may also apply to lifetime earnings, except for young accumulators who should (counter-intuitively) welcome a long period of low asset values at this stage. It is clearly important to revisit household financial plans. If you have never had one, it is the most important thing you can do.

#economics #meanreversion

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