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The cover of Your Money Milestones: A Guide to Making the 9 Most Important Financial Decisions of Your Life, written by Moshe Milevsky
The cover of Your Money Milestones: A Guide to Making the 9 Most Important Financial Decisions of Your Life, written by Moshe Milevsky

Book Excerpt No. 2

Many homeowners should have rented Add to ...

Sure, if you could buy a house that has a bedroom in New York City, a bathroom in Los Angeles, and a kitchen in Chicago and perhaps a garage in Las Vegas, yes, your home would be diversified. Buying a house as an investment has strong similarities to someone being convinced that stocks are good investment in the "long run," but they decide to buy only one stock for their portfolio. I don't care how reliable that one stock is, or how large are the dividends, that stock portfolio is not diversified. The same goes for housing.

In addition, when you are young, your human capital and hence your total wealth is sensitive to the evolution of your wages and income over time. These two factors tend to decline in a recession and bad economic times, just like housing. In other words, there is a good chance that if your job wages take a hit, so will your real estate. I will actually touch upon this concept again in Chapter 8 ("Portfolio Construction: What Asset Class Do You Belong To?"), when I discuss the interaction between your future wages versus stocks, bonds, and other investments. For now, it is simply worth pointing out that if your wages are sensitive to economic conditions; it makes little sense to exposure a large fraction of your financial capital to the same factors by allocating a significant portion of your balance sheet assets to a house. In fact, evidence from the U.S.-based Panel Study of Income Dynamics suggests that controlling for levels of wealth, homeowners actually own less stock-based investments, compared to renters, possibly because of this same reason. Stocks are diversified, tradable, and liquid. Houses are not.

Housing over Time: A Human Capital Approach In sum, a strong argument can be made-absent all the psychic factors involved in the decision-that renting is the optimal choice when you are young.

However, when you are older (say 50 or 60) and you have unlocked a large portion of your illiquid and nontradable human capital and converted it into financial capital, you can afford to "freeze" some financial capital and lock into a home purchase. At that stage, not only do you have more wealth in total, but also your balance sheet (and especially your human capital) is likely not as sensitive to the state of the economy and its disruptive impact on wages. So, Mr. Spock buys his first house-after 25 years of renting-at the age of 50. (Says Spock, "Nowhere am I so desperately needed as among a shipload of illogical humans.") Now, you might justifiably worry here that if you (or Mr. Spock) don't buy a house when you're young, you might never be able to afford a house when you're older. I have heard many real estate agents say that it's important to get a foothold into the real estate market, or you will never be able to afford a house.

Well, I trust that the experience of the last few years has taken some of the air out of this argument. If you examine the inflation-adjusted growth in the price of an average house during the last ten years, as measured by the S&P/Case-Shiller Home Price Index, it equaled only 3.5 per cent. And this doesn't adjust for the often enormous cost of maintenance that is never captured in the long-term datasets.

There's one more dimension that impacts the housing decision and that is the increasing mobility of the labor force. This dimension results in a much higher probability that you might need to relocate for a job, career, or employment opportunities. This is yet another factor that increases the incentive to rent for as long as possible. There is nothing more disruptive to a smooth consumption path (and the practice of Long Division) as having an illiquid and unsellable house serve as an anchor to a region in economic distress.

Finally, if by renting a house (or condo or apartment) instead of buying as soon as possible, you are truly concerned you might miss out on the market, the authors of one of the articles I cited earlier suggest that you hedge and protect yourself against this risk by investing some money in a mutual fund that is linked to real estate prices, such as a real estate investment trust, or REIT.6 This way, you can participate in the increased value of housing, without having to mow a single lawn or unclog even one drain.

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