Tuesday, December 6, 2011

A diversified portfolio of real estate and paper securities makes sense

In earlier posts we have made various comparisons between investing in real estate and in paper securities such as stocks and bonds. One such major difference is that real estate, in particular rental real estate, is a business that , apart from money, requires your time and sweat; i.e. labour, while paper securities provide a return without your labour;  you can receive dividends without having to leave your recliner.

Real estate gives you direct control over the investment asset while stocks and even more so bonds give you little or no control over the asset (other than the right to sell). Also, an investor in real estate can regulate his/her level of risk and cash flow through leverage. With paper securities leverage is often built in and beyond the control of the investor. For example, a bank may have 10 times as much debt than shareowner equity without the investor having a say other than the buy/sell decision.

Here is another matter to consider which relates to diversity. Real estate is local; its performance depends on the economy of where it is constructed. Valuations in Vancouver vary greatly from those in Calgary. Based on affordability, Vancouver real estate is extremely expensive – close to if not in bubble territory - while Calgary is one of the most affordable real estate markets. Vancouver real estate is dependent on overseas investor capital while Calgary’s reflects a combination of inflation and commodity pricing, in particular that of oil and gas.

Compare this dependence on location for a real estate investment to that of the stock market, especially in today’s volatile macro-economic crises. Thethe performances of stock markets througout the world is so strikingly similar that many financial advisors prefer to invest in different sectors rather than regions to build a diverse portfolio.

Canada’s TSX may be a bit of a maverick in this regard as it comprises mostly financial, natural resource and real estate stocks. It is closer correlated to Alberta real estate than many other stock exchanges. U.S. or Chinese securities have a much higher correlation to the global economy. Thus, when investing in real estate, be aware that you are dependent on the local economy which may be quite different from the national or even more so from the global economy; the opposite is true for paper securities. Now that you are aware of these differences, does it not make sense to diversify your portolio in equal weights of real estate and paper securities?

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