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Do homeowners need more bonds or cash?

Posted by admin on January 25, 2010 in Investment Information

Larry McDonald raised an interesting question last week: do homeowners need a greater allocation of bonds? The rationale for such an asset allocation is that housing and stocks are similarly affected by the economy and an allocation of bonds would, theoretically speaking, would not be correlated with the return on housing/stocks.

It is an interesting theory. I am not sure there are any right or wrong answers in the abstract since everyone’s situation is unique but a greater allocation of bonds for homeowners is premised on two assumptions, mainly:

1. Does housing have an equity like return? The thought that housing can produce an equity like return is a relatively recent phenomenon.  As Robert Shiller noted, housing appreciation over long periods of time has a return similar to gold; housing hedges against inflation and gives you a few points of return (there are exceptions based on local effects).
2. There is a strong correlation between the equity market and real estate. I am not certain this is necessarily true (readers?). Looking at the period of 2000-2002, Dimensional Fund Advisors found that the return of U.S. Large Stocks was -9.25%, -12.09% and – 22.23% while the return on REITs in that same period was 28.39%, 13.16% and 4.18%. In other words, equity and real estate actually headed in opposite directions (does anyone have any longer term trending? I readily admit this is much too small of a sample size).  I would take this statistic with a grain of salt since REITs are not perfect proxies for the housing market.

We are, by nature, bad historians. If the new normal is a reversion to a pre-1991 (or pre 1979 depending on whether you believe former Federal Reserve Chair Volcker or Greenspan’s policies created  the conditions for historically anomalous returns), housing should be what our parent’s thought it was; a source of shelter and security and a hedge against inflation and not an asset to be flipped and leveraged. In other words, more like bonds than equity.

However, if you believe the new normal looks a lot like the recent past, than homeowners should own more bonds as an effective asset allocation strategy.

Regardless, I would argue that homeowners should concentrate on their cash allocation- the often over-looked asset class- and debt loads. There are many things to be learned from the housing bubble popping in the U.S. One such lesson is that households who held too much debt, too little equity and too little cash were the first to be wiped out.

A recent homeowner with modest investing acumen and who has little equity in their home may be better off with an aggressive mortgage reduction plan rather than thinking about investing in the market. The counter-argument to this approach is that paying down one’s mortgage gives you lower returns in a low interest rate environment than investing in the market.

This argument is true if the homeowner is a relatively successful investor. If they are not, one may be better taking the bird in the hand and paying down the mortgage (the same argument holds true if the investor is still in shell-shock from 2008; you should not force someone to do something they are not psychologically prepared to do regardless of economic considerations).

What constitutes “aggressive” repayment of mortgages is subject to some debate. The general rule is attempt to make at least one more payment than necessary a year to your mortgage.

The more practical consideration is that housing is a cash cow. It sucks up money like crazy. Thankfully, the winter has been mild and foundation leaks and burst pipes have been few and far between. However, anyone who owns a house knows that every so often you basically burn through cash on something or another. Again, especially for older homes, the building of a large emergency fund first may be more a more practical allocation of investable income than to the bonds and stocks (remembering that bonds do carry the risk of being sold for less than face value).

Two further points about building the emergency fund. If you have to sell your house, you have to put some money in making the house presentable which requires cash. If you have to sell your home because you lost your job, where is that cash going to come from (unlike the States, Canadians cannot simply walk away from a house without some personal liability so some TLC has to be put into the home)?

Secondly, if you never use your emergency fund for housing related purposes, you still have it in the event you lose your job.

Having said all of that, one has to be careful how much of an emergency fund to keep since in a low interest rate environment funds kept outside tax sheltered accounts are basically yielding nil to negative return. They key is to find balance between security and being economically rational. The general guide is typically to keep 3-6 months of fixed costs in an emergency fund.