Monday Morning: A house isn’t just a home for households

Many investors making asset allocation decisions focus only on their holdings of stocks, bonds and cash, and ignore other significant assets: their homes.

For many investors, the wealth locked up in the family home is a significant part of their net worth.

Many count on capturing at least part of the value of their homes to help finance their retirement, either by selling and moving to smaller, less expensive homes or by taking reverse mortgages.

But while those investors are fully aware of the risk of investing in stocks, especially after the recent market declines, most are still not cognizant of the risks inherent in bonds and their homes.

Many feel their homes are an almost risk-free part of their retirement saving.

That is apparent from figures indicating that investors are still pouring money into bonds and bond funds, and still buying homes, driving up home prices.

They are living dangerously. They are betting that interest rates will not soon rise significantly.

They are relying on the continuing patience of the Federal Reserve Board, which could decide at any time that the economy has had enough monetary stimulus and allow interest rates to rise.

Bonds and homes are similar in some ways. Bond prices and home prices react similarly to changes in interest rates. When rates rise, both bond prices and home prices fall, and vice versa.

Bond prices also are affected by changes in the financial condition of the issuer or sector. Likewise, house prices can be affected by changes in the neighborhood.

But there are some crucial differences.

First, quality bonds are far more liquid than houses. An investor can decide to sell his or her bond portfolio, or bond mutual fund shares, in the morning and be rid of them the same day. That can minimize losses.

Houses take far longer to sell, and the investor can continue to see the value of the asset erode during the selling period, if interest rates continue to increase.

The liquidity risk inherent in family homes as investments is at least partly offset by the fact the homeowner can continue to live in the home while waiting to sell the house.

Second, if the investor holds his bonds to maturity they will receive their principal back in full (though this is not true with bond mutual funds).

There is no guarantee that an owner will be able to sell a house for the price originally paid, much less the amount needed needed to help fund retirement.

Third, bond investments can be diversified by issuer and maturity to minimize risk, but only the very wealthy can minimize the risk in their home ownership by buying houses in different parts of the country.

Because of all of these factors, including the value of the investor’s house in structuring the asset allocation is difficult.

But an attempt must be made; otherwise the risk-return profile of the investor’s total portfolio will be wrong.

It is particularly dangerous to ignore the risk in an investor’s real estate exposure at present, given that interest rates are unlikely to fall much further, and the next move up will certainly affect house prices.

As Paul Kasriel, director of economic research at Northern Trust Co. in Chicago, said, Federal Reserve Board Chairman Alan Greenspan is determined to keep interest rates low “to prevent more problems from developing in the mortgage market.”

“A house is not just a home for households,” Mr. Kasriel writes in Positive Economic Commentary, Northern Trust’s newsletter.

“It is once again their single biggest element of net worth,” Mr. Kasriel stresses.

“If housing were to falter, households would suffer yet another blow to their retirement nest eggs,” he adds.

Investors need to be reminded of this fact.

Mike Clowes is the editorial director of InvestmentNews and sister publication Pensions & Investments.