Your home is likely your biggest investment. And your job is likely your biggest source of income. As a result, you should build an investment portfolio that hedges against the risk of losing your job and/or your home.
Many families have much of their wealth tied up in their homes. Particularly younger families that have yet to accumulate much in the way of financial assets. Few people, however, give thought to diversifying against their homes. As Mr. Matthew Spiegel, a Yale finance professor, said in an issue of Forbes, “try to avoid investing in industries that dominate your area, since, if they tank, the value of your house could, too”.
Hedge against your home’s value
This certainly applies if you live in a one-company town. The value of your home will depend upon the company. If it’s expanding its operations, your home’s value should rise, of course. On the other hand, if the company is winding down its operations, the value of your home may plummet. In either case, invest in industries other than the one the company is in. After all, if the company hits a rough patch, chances are other companies in the same industry will also hit a rough patch. In such times, you stand to lose more than enough on your home. At least if your stocks and bonds are in unrelated industries, you’ll limit the damage to your overall wealth.
Remember that this principle applies even in the big cities. If you own a home in Calgary, for instance, you might decide to avoid energy-related stocks or bonds. After all, when the energy sector stumbles badly, home prices in Calgary can drop. If you own a home in central Toronto, you might decide to invest less in financial stocks. If you own a home in Ottawa, you should probably limit your exposure to that city’s high-tech industry. The government is often their top customer.
Hedge against your employer’s stock
Then there’s your job, which for most people will probably generate far more income than any given stock or bond. Here, too, many overlook the importance of diversification.
University of Chicago professor John Cochrane says: “To properly diversify, you should avoid stock not just in your employer but in related ones.” Indeed, if your employer were to go bankrupt, you’d likely need to sell investments to pay your bills until you found another job. If most of your investments were in your bankrupt employer, you would get hit twice as hard, as many former Nortel Networks employees found out.
Some incentives to investing in your employer, of course, are too good to give up. A friend with CIBC in Toronto told us that she could invest up to six per cent of her salary into the bank’s shares. For every dollar she invests, the bank adds 50 cents. This means our friend starts out ahead by a third. Then, too, CIBC shares are very likely to rise in value in the years ahead. Even so, our friend should probably invest the rest of her money in conservative non-financial stocks to reduce the risk in holding so many CIBC shares.
Putting all your eggs in one basket
Your employer may also offer you the type of pension plan where you have several options of where to put the money. In this case, you should choose investments that fit well with your overall portfolio. It seems few people do this.
One study looked at a big employer that offers its workers four bond mutual funds and one stock fund. These workers, on average, put two-thirds of their pension money into bonds. Where employers offer more stock funds, workers end up with mostly stocks. You should choose options that, combined with your other investments, will give you a suitable mix of stocks, bonds and cash.
The founder of U.S. Steel, Andrew Carnegie, once said: “Put all your eggs in one basket and watch that basket very carefully.” Indeed, some argue against the diversification principles outlined above. They say that Calgarians who know the energy industry should stick with what they know and invest in that industry. Similarly, employees often know more about their employers than most investors. So if the outlook is promising, they should invest in their employers.
There’s some truth to this counter-argument, but it’s still worthwhile to diversify against your house and job, just to be safe.
This is an edited version of an article that was originally published for subscribers in the May 5, 2017, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.
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