Thursday, November 25, 2010

Sheltering your investments from the storm

In an earlier post, I examined the "rent vs buy" conundrum and came to the conclusion that -- after making conservative assumptions about the future path of house prices in Australia -- it makes little financial sense for most people to buy property at current valuations. 

As I said back then, many people forget that there is a huge opportunity cost involved in buying property. If you have $100,000 for a deposit, you could invest that money elsewhere for a potentially higher rate of return and lower level of risk. But there's a problem here. If you do expect the housing bubble to burst, you have to expect that there will be significant "collateral damage" in the economy and other asset markets.

So where should you park your money?

Burton Malkiel, the Princeton professor and author of "A Random Walk on Wall Street" has an interesting opinion piece in the Wall Street Journal about the benefits of diversification and "staying the course" in times of market volatility. Consider the chart below:

Now this article is written from the perspective of a US investor, but Malkiel shows how in one of the worst decades for stocks in memory, if a US investor had been well diversified and owned a well balanced index-fund portfolio of bonds, U.S. stocks, foreign stocks (including those from emerging markets) and real-estate securities, he or she would have actually done quite well.

Now I have no particular disagreement with the point that Malkiel makes. But I have to wonder if such a simple approach to diversification is going to work in Australia if the property bubble bursts.

Let's take a look at what might happen in the nightmare (but not altogether improbable) double whammy scenario of an Australian property crash and a sharp slowdown in China.
  • Australian property prices fall 30-40%
  • Australian stockmarket gets hit by a double whammy as resource stocks are clobbered by the China shock and bank stocks collapse thanks to their massive exposure to the property bust
  • China leads a massive selloff in emerging market stocks (no diversification here)
  • Australian dollar collapses to 50-60c
  • Unemployment rises sharply and many are unable to keep paying their mortgage
So again, what to do? First of all, if you do own a house or apartment, it would seem sensible to make sure you have a decent amount of equity in it (say 20% at least) and a buffer of savings so that you can continue to make mortgage payments even if you were to lose your job. Secondly, if all of your wealth is tied up in investment properties, just remember that if there is any kind of crisis, liquidity is suddenly going to vanish and it's going to be very difficult to sell in a hurry. Sadly, this is the position that hundreds of thousands of Australians could find themselves in. And if you do have some savings spare and want to do something to hedge against the risk of a property collapse, you could think about:
  • Term deposits. A quick google search shows you can currently get 6.8% on a two-year term deposit. This is a risk free investment, and it's hard to imagine many asset classes doing better than this if things go wrong. Of course, unfortunately under Australia's ludicrous tax system, you will be taxed at your marginal rate for this sensible investment, the proceeds of which will probably go towards bailing out irresponsible banks and overleveraged property investors
  • Own foreign currency via unhedged foreign stock/bond ETFs or index funds. (although I would be wary of too much stock market risk)
  • If you are are overexposed to Australian resource companies or banks, reduce your share positions or hedge by buying out of the money put options (definitely not for the average punter)
This is just a quick brainstorm, but now is probably a good time to start thinking about these issues. Once the storm starts, it's usually too late to find shelter.
Note: This does not constitute financial advice and you should talk to a qualified financial planner about your individual circumstances before making investment decisions.

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