Evaluate Your <i>Entire</I> Investment Portfolio

In the second quarter of 2004, home prices in Las Vegas rose 52%. Economic data-keepers recently declined to report the average rise in Los Angeles home prices in 2004--the market had risen so fast that it was difficult to arrive at a reasonable estimate. Nationally, housing prices are at an all-time high. According to the Federal Reserve Board, real estate assets on household balance sheets are at an all-time high vs. disposable income, as is mortgage debt's percentage of total household debt.

A typical "balanced" portfolio of 70% stocks, 30% bonds had virtually flat returns from 2000 to 2004--and offered a stomach-churning dose of volatility along the way. With mortgage rates low for much of the period, Americans apparently have preferred to invest in an asset that has been posting much more impressive returns: residential real estate.

What is the problem with such a re-allocation of investments from financial assets like stocks and bonds to "hard assets" like real estate? As Alan Greenspan said last May,

Indexes of house prices based on repeat sales of existing homes have outstripped increases in rents, suggesting at least the possibility of price misalignment in some housing markets. A softening in housing markets would likely be one of the many adjustments that would occur in the wake of an increase in interest rates.

Mr. Greenspan's oracular pronouncements almost always require a certain amount of translation. In this case, Greenspan is pointing out that housing prices are rising faster than rent in some areas of the country. He also might have added that housing prices are rising much faster than personal income. To oversimplify, the ratio of money being sunk into residential real estate to the potential income generated by the assets (rent) is increasing. Which may not seem a problem if you have no intention of renting out your house.

And yet, if all the participants in the residential real estate market are willing to pay more for the same stream of potential income, they must believe that they will be compensated for their investment in some way--in this case, by appreciation in the value of the purchased asset. People are paying higher and higher prices for houses because they expect prices to keep on going up, and without any particular regard to the fundamentals. Sound familiar? This sort of behavior can produce speculative bubbles, as occurred with technology and telecommunications stocks in 1999-2000.

Just as in 1999 when it was easy to forget that stocks could decline, it now is easy to forget that home prices can decline. Your home is an essential investment, just like the stocks and bonds in your investment portfolio, and fluctuations in real estate markets should never change that.

Diversification is key

The potential danger is overemphasizing your exposure to real estate on the assumption that it is the "best" or "safest" investment right now. Buying a second home for investment purposes, buying a new home that is more expensive than you really can afford, or buying residential real estate in a hot housing market with the intention of selling it for a profit are potentially risky decisions, just as diverting more of your income to purchase technology stocks (as so many of us did) was in the late 1990s.

The decision to invest in stocks should be made not in the expectation of short-term gains, but for the long haul, just as a real estate purchase should not depend on an assumption that the property will appreciate in the near future.

In investing, diversification goes beyond the bounds of your portfolio of stocks and bonds. Consider all of your assets, and judge how they are balanced. If your disposable income is being overallocated to one type of investment, whether it be stocks, precious metals, or real estate, you may be taking an unnecessary risk. As the Talmud put it some 3000 years ago:

Let every man divide his money into three parts, and invest a third in land, a third in business, and a third let him keep in reserve.

The point being, of course, that moderation, caution, and balance almost always serve us well.

Jeremy Stark, of CUNA Mutual Group and MEMBERS Capital Advisors, provides economic and financial market analysis and investment advice for institutional clients in the credit union system. The CUNA Mutual Group is the leading provider of financial services to credit unions and their members nationwide. MEMBERS Capital Advisors is CUNA Mutual's registered investment advisor affiliate.

Published February 14, 2005