The Ignorant Investor

I read an article in the Wall Street Journal called “New Tools to Hedge Your Home” today. This rather silly article begins with the premise that now that Americans have built up large stakes of equity in their homes, they need to find some way to protect that should housing prices fall significantly. One method cited by the author:

Amid warnings from economists that real-estate values in some parts of the country may drop eventually, there is a nascent movement to offer new investment products designed partly to hedge against falling property prices. The goal: Offer limited protection against the risk of riding real-estate prices back down again after the record run-up in recent years.

Translation: buy options that pay off if home values drop. Problem is, 1) you have to pay to get the options, and 2) the options expire. Once, twice, three times you buy them, never knowing whether you’re actually going to need them and hoping you never do. These are expensive toys to play with, and to my conservative way of thinking no ignorant investor in his or her right mind would go near them.
The article flirts around various other methods- locking in a low interest rate, selling the home to lock in gains, but it never really addresses the point everyone should understand: there is literally no sure way to protect gains in home equity, any more than there is to protect gains in any other asset class. You can turn real estate into cash, but if inflation roars back then cash loses its value. Put the cash in the stock market? Your portfolio drops if the market suffers a big downturn. Put it back into property? You risk higher rates and fewer buyers and maybe a deflating bubble. It’s the financial equivalent of a game of rock, paper, scissors: every investment has some critical weak point that the future may someday penetrate.

Diversification across asset classes can minimize the risk of a loss from any single asset class, because often when value in one asset class drops sharply, the value of another doesn’t. A section of the article evidences this fact when it talks about the performance of stocks versus home prices over the past few years:

Since 1999, Americans' equity in their homes has soared 68%, to nearly $10 trillion in this year's first quarter, according to Federal Reserve data. During the same time, the value of stocks and mutual-fund shares held by households and nonprofit groups has declined 18% and also equals about $10 trillion.

But watch the way one investor takes this information and derives exactly the wrong lesson from it:

Tom Atkin, a 58-year-old marketing consultant, nine years ago paid about $335,000 for a three-bedroom ranch house in the San Fernando Valley near Los Angeles. He figures it is now valued at well over $1 million, and has thought about selling his home now while the market is hot and moving to a less-expensive area. One problem, he says: "I wouldn't know where to put all the cash [from the sale] that would earn as good a return."

Notice that Tom looks at how much his home is worth now and assumes that 1) the rate of return will continue to be better than stocks, and 2) that the value of his home only grows. Tom is still bullish on real estate even as home prices are well above their historical average growth rates of 6% a year over the past few decades (barely 2% above the average rate of inflation in the same period). To me, that’s betting against the fact that prices tend to regress to the mean. He may be right, I may be wrong. But I’ve got history on my side. Could be that both stocks and houses are in for a period of levelling out, absorbing the higher than average gains we've seen in both asset types over the past ten years. Or they both could be headed for a significant fall. How's that for a comforting thought?

Here’s the point the article should have made: If you’ve seen tremendous growth in the value of your home, there really isn’t anyway you can protect it without taking on additional risks that none of us can estimate with any certainty right now. The history of investing shows that we've had periods where losses are widespread but not permanent. What I do is, I assume that if I’ve made 100% over the past five years, maybe I won’t keep all that gain. Or maybe I will. Who knows? But don’t ignore other assets classes like cash, stocks, bonds, gold, etc. Diversify. Eggs in separate baskets, etc.