In previous posts, I have covered the following topics related to mortgage payments and asset allocation:

• My Money Blog - How Mortgage Payments Fit in to Account Payments Hierarchy
• My Money Blog - Target Asset Allocation

However, in these posts, I did not include exactly how the mortgage payments (and resulting home equity that is built) should fit in to your overall asset allocation target/strategy. This will be the subject of today's posting.

To try to shed some light on this topic, let's first see what the financial advisors do to handle this question. We will then see how we need to adapt their strategy since we have no restrictions with what we do.

How do financial professionals handle the asset allocation strategy with home equity?
Through an examination of the opinions of the financial press (see three links below), I discovered that there are basically three "camps" when it comes to opinions on how home equity should be treated when it comes to figuring out your overall asset allocation.

1) Not including home equity in the target asset allocation percentages at all.

This approach is generally taken because real estate values/equity are difficult to determine exactly and because most of the time, it is not possible to adjust your allocation %'s in real estate because you cannot simply leave a house for another one.

2) Not including home equity in asset allocation percentages unless it is an investment property (so not including including your primary residence).

This approach of excluding your primary residence from your asset allocation decision making is taken because of the fact that you NEED a place to live, and you cannot simply exchange your home for shares of a mutual fund if your allocation %'s change.

3) Include all residences, investment properties, and REIT investments as a "real estate" category in your asset allocation strategy.

This approach is generally taken to have a conservative strategy that ensures that all assets are captured. However, since it is a little harder to follow, it is generally the least popular strategy.

MyMoneyBlog - Home Equity in Asset Allocation
BusinessWeek.com - Home Equity in Asset Allocation?
Investment News - Including Home Equity in Asset Allocation

Which approach will I take?
I believe that for my needs, situation, and investment style, I am going to choose to follow Approach #1 - not including my future home equity in the property I am planning to purchase this fall - with a slight adjustment.

Why is this exactly?
In short, home equity in a single house cannot be considered exposure to real estate because it is not diversified enough.

A passage on pages 282-285 of one of my favorite asset allocation books titled, "What Wall Street Doesn't Want You to Know," by Larry Swedroe does a great job of breaking this down in to terms the layperson can understand.

In the book, Swedroe describes that your home is clearly real estate.

However, it is very undiversified real estate in the following ways:

• It is undiversified by type (aka office, warehouse, industrial, multifamily residential, single family residential, hotel, etc) and owning a single family home only gives you exposure to a small piece of the overall real estate sector.
• It is undiversified geographically (meaning that real estate prices in different areas of the country vary greatly due to what employers are present there and how well they are doing - just think of if you lived in a small town where 90% of the wealth comes from one manufacturing company, and that one company shuts down. Real estate prices will plummet).

So, because the home you live in is very undiversified, counting it towards the real estate portion of your overall asset allocation would be as foolish as a Pfizer executive counting a large quantity of Pfizer stock as their sole exposure to large cap US asset class. They are really not diversified one bit.

Since owning even one share of an index real estate investment mutual fund, such as a REIT that Vanguard, gives you broad exposure to all types of real estate across many different regions, this should be the route that is chosen to represent the real estate portion of your asset allocation picture.



So, how will I treat/consider my home purchase since I am not including it in my asset allocation mix?
Just to recap - in my mind, I want to purchase a home vs. rent one for the following reasons:

1. I am always going to need to live somewhere.
2. To take advantage of the tax benefits associated with home ownership, such as tax deductions for property taxes and interest payments (see information at the following link - My Money Blog - Tax Benefits of Home Ownership)
3. To gain some equity and increase my net worth while making my cost of living payments.

On a similar note, I would want to invest in additional real estate properties to take advantage of tax benefits of home ownership, such as being excluded from paying capital gains on profit from selling the property (described in previous post at link above).

Given the considerations above, here's the way I will treat home equity:

• Shoot for getting as close as possible to paying a 20% downpayment, since this reduces cost by having to avoid Prive Mortgage Insurance.
• Sign up for a bi-weekly mortgage payment plan and pay off mortgage according to that schedule (see post at following link for more information My Money Blog - Biweekly Mortgage Payment Plan), according to the My Money Blog - Account Hierarchy.
• Track my home equity as part of my net worth, but not in my overall asset allocation targets.
• Continue to pay off my biweekly payments on my mortgage through graduate school, aspiring to obtain 40-45% of my net worth in property ownership, as recommended by the article from Business Week (see link above for more details).
• A number of years down the road, if it becomes apparent that the % of my net worth that is represented by property ownership dips too far below 40%, I would then use that % as a starting place to make a decision if I would want to invest in additional rental property.

So, I hope this investigation/discussion helps guide you through some of the tough decisions you will have to make regarding how you will treat home ownership. As always, please let me know if you have any questions.

Keep on learning!

Jacob

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