Diversification is critical to prudent investing because it reduces risk. To be effective, diversification must be across assets that have low correlation. Real estate has low correlation with other asset classes and thus is an effective diversifier that should be considered when constructing your portfolio. A problem arises, however, if you consider your home as your real estate allocation.

While a home is real estate, it is undiversified by type and geography. There are many types of real estate: office, industrial, hotel, and so on. A home is exposure to just the single-family sector of the asset class. And home prices might be rising in one part of the country and falling in another.

Another problem is that home prices may be more related to an industry than to real estate. For example, home prices in oil producing regions fell in the 1980s when oil prices collapsed, yet real estate investment trusts (REITs) returned 16 percent per annum during that decade.

A related problem is that employment prospects can be correlated with the value of your home. The problem compounds if your investment portfolio is loaded with stocks in the same industry to which your home is exposed. This is often true of executives who own stock/options in their company.

The following example illustrates the potential problem. Seattle was once a "company" (Boeing) town. An executive at Boeing who owned an expensive Seattle home and had a large percentage of her financial assets in Boeing stock might have thought she had some diversification of assets because of that home. However, there have been several periods when Boeing has been impacted by a recession in the airline industry. Overall, how did Boeing employees fare?

• The company's stock, reflecting those troubles, fell sharply. Strike one.
• Boeing reacted by firing many employees. Strike two.
• With unemployment rising, Seattle home prices collapsed. Strike three.

The problem was that all of the risks - employment, stocks, home - to which our investor was exposed were highly correlated. This is less of a problem today in Seattle, but there are many places where this could be an issue.

Owning a home and considering it exposure to real estate is like being an executive with lots of stock/options in Microsoft and thinking you have exposure to large-cap growth stocks. The correlation of one stock to its asset class can be low. Stocks might be up, but your stock might be down. Similarly, REITs provided solid returns in 2006, yet home prices fell in many locations.

Another problem with treating your house as exposure to real estate is that you cannot rebalance or tax manage like you can with equities.  

Don't Forget the Mortgage

If you financed your home, any mortgage should be considered a negative bond position, and netted against other fixed income holdings when calculating your asset allocation. The type of mortgage should also be considered. A fixed rate mortgage provides protection against rising rates. And if interest rates decline, you can refinance, providing protection against falling rates. On the other hand, the rate on adjustable rate mortgages change as interest rates change, exposing you to the risk of rising rates. Therefore, you should consider how a home is financed in developing your investment strategy.

Summary

While a home is real estate, the best way to obtain exposure to the asset class is to purchase an index fund (or exchange-traded fund) that invests in a broad spectrum of REITs. Treat your home as a consumption item, albeit one with value that should be on your balance sheet, just not part of your investment strategy.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The articles and opinions in this publication are for general information only and are not intended to serve as specific financial, accounting or tax advice. Copyright © 2008, Buckingham Family of Financial Services. All rights reserved. This material may not be copied or distributed (electronically or otherwise) without the written consent of Buckingham Asset Management. The products or services described herein are available to US citizens and residents only and the information contained is intended for such persons only. No information contained herein is an offer to sell. Investors should read the prospectus of a security prior to making any investments. Please contact us if you have any questions at 314.725.0455.