Your house is likely your biggest investment. And your job is likely your biggest source of income. As a result, invest in a way that diversifies away from your house and your job.
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 houses. 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”.
Diversify away from your house
This certainly applies if you live in a one-company town. The value of your house will depend upon the company. If it’s expanding its operations, your house value should rise, of course. On the other hand, if the company is winding down its operations, the value of your house 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 house. At least if your stocks and bonds are in unrelated industries, you’ll limit the damage to your overall wealth.
Keep in mind that this principle applies even in the bigger cities. If you own a house in Calgary, for example, you might decide to buy no energy-related stocks. After all, if the energy sector stumbles badly, house prices in Calgary could drop sharply (as they did in the mid-1980s). If you own a house in central Toronto, you might decide to invest less in financial stocks. If you own a house in Ottawa, you should probably limit your exposure to the local high-tech industry.
Diversify away from your employer
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 stocks 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 Nortel Networks employees and retirees found out.
Some incentives to investing in your employer are too good to give up. A friend with Canadian Imperial Bank of Commerce told us that she can put 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 that our friend starts out ahead by a third. Then, too, CIBC shares are likely to rise in value in the years ahead. Even so, our friend should probably invest the rest of her money in conservative non-bank stocks, to reduce the risk in holding so many CIBC shares.
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.
Choose investments that suit you
One study looked at a big employer that offers its workers four Canadian bond 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, Mr. 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 these counter-arguments. But it’s still worthwhile to diversify against your house and job, just to be safe.
The Investment Reporter, MPL Communications Inc.
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