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.

Saving up for a car

I've figured out a way you can save thousands of dollars on your next car. I call it saving up for it. It's pretty radical, but if you bear with me, I'll explain how it works.

Say it's 2004, you live in Ontario, and you'd like to buy yourself a 2004 Honda Civic. It will cost you about $16,100, plus $2093 tax, plus $2049 interest if you finance it at 6% over 4 years. Total cost: $20,242.

Now, let's suppose instead that you just pretend to buy the car, but actually you decide you'll get by with your current rust bucket, and pay yourself the $378 car payment every month into a a bank account, and -- get this -- the bank pays you 3% interest! After 4 years, you can buy yourself the same car for $12,600. You save $3500 off the sticker price, and $455 in tax. Best of all, instead of paying $2049 in interest, you actually earn $1024 instead (though that income is taxable). Net cost: $13,600.

You save yourself almost $7000, and you end up with the same car. Even if your existing car costs you an extra $2000 in maintenance compared with the new one, you're still $5000 ahead. If you invest that, and it doubles every decade for three decades, you have an additional $40,000 in retirement, which is more than your final two RRSP contributions put together.

And that's why I'm still driving my family of four around in a 13-year-old coupe.