In 1776, Adam Smith wrote The Wealth of Nations, one of the most important economic texts ever written.
He only mentioned the phrase “the invisible hand” three times in the work, yet this has become one of the key economic theories and remained so over more than two centuries.
Smith noted that an individual:
“…neither intends to promote the public interest, nor knows how much he is promoting it….he intends his own gain, and he in this…is led by an invisible hand to promote an end which was no part his intention.
By pursuing his own interest he frequently promotes that of the society more effectually than when he promotes it. I have never known much good done by those who affected to trade for the public good.”
If such a passage would create a stir today, imagine its impact in 1776!
The invisible hand translated
What Smith is promoting here is a clear argument in favour of free markets, suggesting that in acting in their own interests, individuals bring markets into a natural equilibrium.
Interventions from governments and other bodies, he suggests, create as many problems as they solve.
Likewise, if a product or asset is priced too high then it will not be bought.In essence if a company provides a product for which there is no demand, then society at large will not buy it.
The natural outcome is that jobs and wealth for society at large are created by successful companies who are producing goods for which there is both a need and a desire.
Of course, companies are acting in their own self-interest, and yet indirectly they provide society with great benefits.
As competitors come into the market, companies are forced by the invisible hand to price their products more cheaply and society benefits yet further.
The simple idea of the invisible hand is indelibly and inextricably linked, therefore, to the familiar twin concepts of supply and demand.
The invisible hand in action
There are countless examples of successful companies bringing out new products in order to attract new markets of customers.
What often happens is that society rejects the new product in favour of the more popular existing ones and the invisible hand gives the company a metaphorical ‘slap on the wrist’ by shunning it.
The most famous example of all was the introduction of ‘New Coke’ which was universally unpopular with the customer base, thereby forcing the Coca Cola Company to revert to its original product.
Problems with the invisible hand
While the laws of supply and demand are generally a sound argument in favour of free markets, even the staunchest advocate would have to accept that free markets can be allowed to run too far.
The clearest modern example we have is in pollution and its potential effect on the climate. Allowing companies to act entirely as they wish is not a desirable outcome for they will pollute the planet to its detriment.
This is what Smith called “the tragedy of the commons” – that sometimes free markets allow participants to act too far in their own interest to the detriment of others.
Consequently, argues Smith, we all need to accept that some level of laws and regulations are needed and governing bodies must intervene from time to time to defend the common good.
And so to house prices
There are two schools of thought on the effect of the invisible hand on the price of dwellings.
On the one hand, it seems logical that the free markets should be allowed to run, and the price of a house should find its own level.
In acting in their own self-interest, homeowners and investors should theoretically price dwellings at their fair value in the same way as any other asset.
If a house is priced too expensively no buyer will be found, and buyers will look elsewhere.
However, one of the problems with house prices is that there never has been a ready way to find a fair value.
A share price we can rationally value at the sum of all projected cash flows, but what of a property price? 3 times income? 20 times the annual rent? 4 times income? Based upon imputed rents?
There never has been and can never be an agreed upon figure. A property is simply worth what someone is prepared to pay for it. No more, no less.
It is clear that from time to time, the Reserve Bank and the Government will intervene where they believe properties prices have escaped too far from what they deem to be a ‘fair value’, but ultimately, the market will speak and prices will be determined by the invisible hand.
The inescapable conclusion for property investors
From time to time, smart people with flash-sounding company names will arrive on the scene, promoting cool new ideas for property investors.
One day it will be uranium mining towns. Another day it will be investing in properties in remote areas, which on the face of it seem to pay a nice rent.
Tomorrow it will be property options, and next week it will be flipping properties for a quick profit.
My advice is always to take a step back.
If you want to be a successful property investor, you need to be able to shut out all of the noise. Strip it back to the most basic level and think of the invisible hand.
What determines the price of a property and what price it will be worth in the future?
The invisible hand tells you: the most expensive properties in 2050 will be those for which there is the greatest demand.
Now consider this: where do most people want to live and what types of property are they increasingly choosing to live in?
Finally, acknowledge that for better or worse, Governments and Reserve Bank Governors will come and go, the population will continue to boom and there will periodically be ideas thrown at the property market in various attempts to intervene and control the level of prices.
As an investor, take the supply factor out of the equation.
Only buy properties where there is a very limited opportunity for governing bodies to intervene and increase the supply.
That means in suburbs which are landlocked and fully built out.
Stick to those basics and you shouldn’t go too far wrong in Australian property.
Though I did hear about this clever new idea…