Investing and Financial Planning in an Era of Uncertainty, Risk and Illusion

For anyone who’s managing their own investments, or who’s planning for eventual retirement, Robert Shiller made some important points in an article published last Thursday:

The closest we can come to Trump among former US presidents might be Calvin Coolidge, an extremely pro-business tax cutter. “The chief business of the American people is business,” Coolidge famously declared, while his treasury secretary, Andrew Mellon – one of America’s wealthiest men – advocated tax cuts for the rich, which would “trickle down” in benefits to the less fortunate.

The US economy during the Coolidge administration was very successful, but the boom ended badly in 1929, just after Coolidge stepped down, with the stock-market crash and the beginning of the Great Depression. During the 1930s, the 1920s were looked upon wistfully, but also as a time of fakery and cheating.

Of course, history is never destiny, and Coolidge is only one observation – hardly a solid basis for a forecast. Moreover, unlike Trump, both Coolidge and Mellon were levelheaded and temperate in their manner.

But add to the Trump effect all the attention paid to Dow 20,000, and we have the makings of a powerful illusion.

Not a day goes by that I don’t ponder what’s around the next corner (economically and financially). Or how investments and assets should be deployed and managed.

It seems a few things are indisputable:

  1. There is above-average uncertainty today.
  2. Risk is greater than acknowledged or priced into the market.
  3. Illusions are dangerous underpinnings for decision-making.
  4. Assets can lose value (for a long time or permanently).
  5. Our bias is optimism.

That’s life, Vera. Uncertainty. Risk. Illusions. Unknowns. Biases.

Plan accordingly. And choose wisely.

Treat Your House as a Home, Not an Investment

We live in a hot real estate market. Colorado and, in particular, what’s called the Front Range (roughly, the populated area on the east side of the Rockies extending from Cheyenne to Pueblo) are highly desirable areas. Each year thousands of people move here from other parts of the country. I was one of them in 2012. All else being equal, I can’t think of a better place to live.

Due to the increased demand for housing and relatively high site development costs (for instance, it cost $30,000 just to tap into the water line for a new house where we live), the housing supply is limited. In general, especially from Denver to Boulder to Fort Collins (our home turf), demand exceeds supply.

So you’d think that houses that are put on the market would sell quickly. And some do. But quite a few don’t.

Frequently, we walk around a golf course that’s just to the north of our neighborhood. One thing we’ve noticed over the three plus years we’ve lived here is the length of time it takes for some houses to sell in the neighborhoods adjacent to the golf course. Just now there are several houses that have been sitting on the market for months. The houses are nice, in a great location and some have fantastic views. So what gives?

My intuition has been confirmed by some local realtors I know. The problem is the owners: They’re simply unwilling to sell for the price prospective buyers are willing to pay.

On the surface, this seems crazy. Price is set by the market. If your property doesn’t sell because it’s priced too high, then drop the price. It will sell. Yet many sellers of houses are stubborn. They refuse to hear what the market is telling them.

This situation isn’t unique to the Front Range. When we lived in Virginia, I knew a guy who had been sitting on his former (then vacant) home for a couple of years or more. The house was worth $x, he thought, and he wasn’t going to sell it for less. It didn’t matter what the market had to say.

So what’s the root cause of this seemingly irrational behavior? It stems, I believe, from the mistaken belief that your home is an investment. And from our tendency to be guided by emotions and not reason. (See We Live In an Irrational World)

Now, it’s true that a few people have made lots of money selling their homes. But, on average, they don’t.

Most people break even at best (after factoring in inflation, maintenance, mortgage interest and taxes, or when comparing the cost to what they would have spent by renting); many people don’t even do that well. On average, treating your house as an investment is not a sound investment decision. Indeed, housing has yielded an average annual return of only 0.2% over the past 100 years.

There have been exceptions. If an area becomes hot (for example, because of a major employer moving into the area), or if a bubble forms in the housing market (which has happened from time to time and undoubtedly will happen again), then the value of a house can become inflated, thereby yielding a robust return on investment if you sell before the bubble bursts. Moreover, if you buy your house when the housing market has collapsed, then you eventually may well earn a robust return simply because you bought at the right time. But those are the exceptions.

Yet the exceptions appear to form the general rule. Hence, some people come to believe their homes are not only a place to live but also their principal investment vehicle. So, when it comes time to sell, they allow their homes to sit on the market, waiting for the bigger fool to come along. Sometimes that fool appears, but more often than not he doesn’t.

I suspect another reason for this stubbornness on the part of sellers is their dependency on this asset stemming from their lack of alternative investments. They want to make a killing because their financial well-being depends on it. Or perhaps they overpaid when they bought it and can’t bring themselves to take a loss when they sell it.

A sense of desperation leads to poor decisions. So does loss aversion. Take note, Vera: those principles extend far beyond housing decisions.

There are good reasons to own a house. But there are some flimsy ones, too.

If you choose to buy instead of rent, Vera, remember this: the prudent course of action is to treat your house as a home, not an investment.

More generally, it’s prudent to endeavor to be rational and not emotional when it comes to your finances. Perhaps without exception in the world of investments, emotions will lead you astray.

Invest in the Right Assets

Many Americans invest in assets like McMansions, fancy cars and tons of stuff around the house they really don’t need.

At least I assume they don’t need much of it or our countryside wouldn’t be peppered with storage facilities. We just completed a long trip to see you in Indy, Vera. It’s amazing how many storage facilities we saw along the way, even in communities that didn’t look particularly well off.

In any event, here’s my perspective on the subject of investments: buy assets that produce income. Continue reading Invest in the Right Assets