Wall Street shows the way, part 1: risk tolerance.
How the pros educate their clients and avoid liability.
I hate to admit it, but I haven't been too upset by Wall Street's self-serving machinations during the credit crisis. When an investment bank uses bail-out money to buy another bank or hand out year-end bonuses, I think of course. I expect an industry to look out for Number One, as much as its customers let it.
A recent experience with Wall Street, up close and personal, affirms my awe, if not admiration, for this venerable—or at least really old—and wily institution.
As you may know, there's been some discussion lately about how responsible the real estate industry is for the various economic catastrophes that have played out, locally and nationally, since whenever (and if) real estate went belly up in your neck of the woods. Didn't the industry have an obligation to warn its clients that what goes up often comes down, at least in the short term?
It was with this in mind that I plowed through twenty-one pages of turgid fine print sent me recently by the asset management division of a major Wall Street investment banker. If any of my clients complain about having to plow through the mere eight pages of turgid fine print that's our local real estate purchase contract, I'll show them a certain "client agreement".
Better yet, the real estate industry should adopt its key provisions.
First there's a fun part, as there always should be, in this case an "investor questionnaire", eight pages that'll either scare you out of the stock market or fool you into thinking you have nerves of steel. I'll modify its stock-market oriented questions to suit buyers of real estate.
1. What is your primary purpose for buying real estate?
| □ own my own home □ tax advantages □ peer-group pressure |
| □ long-term wealth accumulation □ a quick buck □ nothing good on TV this season |
2. How quickly do you expect to begin realizing your investment objective?
□ over 20 years □ 6-10 years □ what time is it?
□ 11-20 years □ 1-5 years
I think you get the idea. Why are you in the market? Are you really in the market, or just taking up space? How realistic are your goals?
Next we move to the crux of the issue, risk tolerance. First you're asked to identify which of three blends of risk and reward you're comfortable with. The next shows three graphs of hypothetical annual market performance, ranging from small but consistently positive returns, to greater but more volatile returns, to even greater but even more nerve-wracking returns.
The next question is one that, as a self-professed risk taker who supposedly understands markets, I failed miserably. It shows four stock market portfolios, each with an initial investment of $100,000. Portfolio A offers an annual return of 7 percent but carries a 19 percent chance of losing money. Portfolio B offers an 8 percent return, a nice 14 percent increase over Portfolio A, but runs a 23 percent risk of losing money—in other words, Portfolio B is 21 percent riskier than Portfolio A, while offering a return that's only 14 percent higher than Portfolio A's "safe and sane" approach to wealth creation. We'll skip Portfolio C and go directly to maximum strength Portfolio D, which offers a whopping 10 percent rate of return that's a whopping 43 percent higher than Portfolio A but carries an extra-whopping 47 percent more risk.
I look at this and think, "Mama didn't raise no fool" and firmly check Portfolio A, the most conservative. Because despite what any fast-talking agent—excuse me, stockbroker—tries to tell me, the other portfolios just don't add up. Who'd trade greater returns for all that risk? Not realizing until the next day that, duh, that's what the market is all about. That "measly" point or so of extra annual return your portfolio manages to eke out over the long term comes not just with higher highs but lower lows.
Whoa! What a lesson! Extra return means extra risk! Always! And anyone who thinks otherwise is ready for a plucking!
But can this hard lesson from the stock market be of use to home buyers?
Yes, I think, to some extent. Experience tells me that home buyers differ from stock market investors in one key way, often missed by self-proclaimed experts: home buyers are far less driven to grab the brass ring. Sure, building net worth is one of the drivers of real estate, but you'd be amazed at how infrequently my clients mention this. (It amazes me, at any rate.) And when they do, I worry, because it means they'll be analyzing any potential purchase nine ways from Sunday, without adequate information (despite the Internet) or insight, complicating an already overwhelming process and staggering away with a bad case of brain overload.
But there is one characteristic common to many participants in both markets: market timing. That's the short name for it. The longer, better name is "I'll buy only when it's the perfect time to buy, when the stars are aligned so that reward is optimized and risk is minimized".
Short name or long, it's a popular "risk-avoidance" strategy ("strategy") commonly expressed in pearls of conventional wisdom such as "no one's buying these days, so it must be a bad time to buy" or "everyone's buying these days so hey! it must be a good time to buy". These are, of course, two different ways of saying the same thing, that it's way too risky and financially unrewarding to buy in a "bad market". The ideal time—the only time—to buy is in a "good market", when perceived risk is low, perceived reward is high and buyers crowd open houses. A "bad market", on the other hand, is whenever the outlook is uncertain, prices are falling and people are driving right past open house signs. Talk about scary risk! In fact, instead of calling markets "good" and "bad", it might be more reflective of market psychology to call them "friendly" and "scary".
So I know everyone here agrees that in a "bad market" like, say, late 2008, when the world's financial system seemed poised for collapse, you hunker down and wait for assets to snap back to their old habit of offering big returns with minimal risk.
Never mind that real estate, like the stock market, never offers big returns with minimal risk. Also never mind that in a "bad market" almost everyone is hunkered down, which means they aren't competing with the few "fools" still active in the market, which means said "fools" are getting in fewer bidding wars, which means they run less risk of "paying too much", which maximizes their chance of getting big returns. Also never mind that in a "bad market" almost everyone hunkered down is waiting for the same signs the market is back to offering big returns with minimal risk not, which means almost everyone will stop hunkering and start buying at the same time, which means that real estate buyers are more likely to get in bidding wars, which means they've jumped into the market just as home prices go up, which takes a big chunk out of their potential return.
Which is risk avoidance with a twist.
Still, most people will assure you safe and sane is the way to go. Buy only when it's sunny and clear, because that's when you get the big financial rewards of homeownership without the big risk. Talk about win win! Risk is for people who haven't figured things out. Only the naive buy when the market is dark and stormy.
But some people know that every real estate market, "good" or "bad", "buy" or "no buy", is neither good nor bad, buy or no buy. Instead, each part of the real estate cycle is like one of those four stock market portfolios, neither good or bad, each just a different level of risk and commensurate reward.
The many who hunker until there's nothing but sunshine have firmly checked Portfolio A, intuitively and often without understanding the consequences. The few who venture out in any weather have just as firmly checked Portfolio B, C or D.
Over the long run, those who take the greatest calculated risk get the highest rate of return.
Next week, Wall Street shows the way, part 2: "investor risk".