Blog: Cutting Through the Noise
Become Your Own Hedge Fund Manager. Buy a Home.Print
Posted on June 21, 2007
My wife tells me I can be a real downer at parties. There are lots of reasons why she says that, but one is that I just can’t help myself when people start telling me how well they’ve done on their real estate purchases. I’m probably just bitter because we haven’t done as well, but in any case, I always feel obliged to point out that if they had invested the money in a diversified portfolio of financial assets, the returns would have been even better.
Lately, I’ve been trying to improve my party etiquette, however. That’s partly because we should all keep working at this marriage thing, and partly because I’ve been wrong all these years. Well actually, I haven’t been wrong ‘technically.’ If you compare the stock market indices to the house price indices over long periods of time, it would appear that I can keep being a downer for many years to come. But in reality, I’ve been very wrong.
The reason: leverage. Using the house price index in the comparison is not reflective of what homeowners’ experience has been. Through the wonders of leverage in a rising market, homeowners have done much better.
Consider a simple example. Let’s say you buy a house for $200,000 and put a $150,000 mortgage on it. If the house appreciates 50% in value to $300,000, your $50,000 of equity has tripled to $150,000. That’s because you get to keep all the gain while the bank doesn’t participate at all - it just gets its money back.
This simple math leads me to the point of this posting. If you think about it, home ownership is the closest many of us will get to being a hedge fund manager, or even investing in a hedge fund. Without knowing it, we are pursuing one of the most common strategies pursued by hedge funds. We are borrowing ‘short’ to buy a ‘long-term’ asset. Mortgages of one to five years certainly qualify as short-term borrowing. The house, on the other hand, is a long-term asset: it is not easily tradable and the magnitude of price changes can be dramatic. So like a hedge fund, we win big when the market for our long-term asset is going up. And it has been a good market for all long-term assets since 1981 when interest rates peaked and started their inexorable decline over the next twenty-five years.
The reason the capital markets, and guys like me, are so worried about a housing decline in the U.S. is that leverage works the other way as well. Equity can also disappear quickly if there’s a big mortgage on the home.
Very few individual investors have the money or connections to participate in hedge funds. It’s a game for people or organizations with big money and lots of resources. But through home ownership, we are all behaving like a typical hedge fund. The financial leverage that allows us to buy the house also has the effect of amping up, or down, our returns on the investment.
So the next time you want to impress someone at a party, don’t follow my strategy. Instead, break the ice by telling them that you’re running your own hedge fund. Even better, tell them you’re living in it.