A Canadian's random thoughts on personal finance

May 30, 2008

That's diversification?

In Larry MacDonald's recent blog post, he made clear his uneasiness with having your whole wealth invested in your home—a position I agree with. He went on to say that he'd suggest keeping 15-20% of your wealth in the form of other assets to protect yourself from a drop in housing prices that may amount to as much as 30%.

Let's examine this diversification strategy for a moment. If you have 20% of your wealth in other assets, you still have 80% of your wealth in your home. This means that a 30% drop in your home's value equates to a 24% drop in your wealth. The undiversified home owner would end up with 70¢ for each dollar he has today, while the "diversified" one would have 76¢. That doesn't sound like much protection to me.

In contrast, I have no real estate, but suppose I invest in funds that have 10% invested in Real Estate Investment Trusts (REITs). If the unit prices of those trusts were to drop by 30%, I would still have 97¢ for each dollar I have today. Now that is the protection that diversification is supposed to provide.

Naturally, I also don't stand to gain as much if REITs suddenly rise in unit price. But let me tell you what does happen. If REITs suddenly double, I'd have 20% of my assets in REITs. The managers of these funds aim to have 10% in REITs, so to achieve the target asset balance, they would sell half of my REIT holdings and buy other assets instead. Conversely, when REITs drop, they would buy more to keep the target asset balance.

In other words, they buy low and sell high. It's hard to complain about that.