A collection of essays by Bill (website@ccjj.info) accompanied by feedback from his friends.

Sunday, February 21, 2010

Real Estate: Evils of the Owner-Occupied Paradigm

For many years, it has been the conventional wisdom in the United States that home ownership was the best investment strategy for the average person. Since 2006, we have seen real estate prices drop 32% nationwide and more severely than that in some areas, and along with that, we have seen a rash of foreclosures. The time is ripe to be rethinking our investment strategies.

US Home Prices Nationwide: 1994 - mid 2009
Reasons Why Buying the House You Live In Is Not a Good Idea

Diversification: One of the most important factors in an investment strategy should be diversification. You want a lot of little investments, of different types, so that if one investment goes sour, it doesn't wipe out your whole portfolio. You can't get much less diversified than a house -- not only is it a single investment, but if you start out with a 10% down payment, that house is 1000% of your portfolio! So if the house declines in value by 10%, you lose 100% of your initial investment.
Potential Debt: The traditional way to buy a house is on credit. You are investing with money that is not yours. That means that a small increase in the house's value will result in a large payoff for your initial investment. Many people experienced this prior to 2006, seeing huge increases in their net worth as their homes appreciated. It also means that a small decrease can leave you with negative net worth. In my book, having negative net worth is many times more bad than being rich is good. I prefer not to invest money I don't have, and follow an investment strategy where the worst case outcome is flat broke.
Pre-Bubble Mentality:
Prior to 2005, most people buying real estate believed it was a fundamental law of physics that real estate prices would always rise. When most people are thinking that way, it is called a bubble. It was a matter of time until the bubble burst.
Planning For Hard Times:
It really is a good idea to have sufficient savings to carry you through a couple of years of unemployment. Relying on credit to get you through tough times is risky -- banks respond to tough times by restricting credit. Furthermore, a computer glitch or identity theft can destroy your credit rating at any time. Generally, a mortgage payment is much higher than a rent payment for the same sized dwelling. And if you become unemployed for an extended period of time, you'll have no income to write off the mortgage interest against during that time.
When the economy goes badly, the banks are reluctant to extend credit, and are raising interest rates and lowering credit limits. If you rent your dwelling, then when hard times hit, you can easily move into more modest accomodations. If you own your dwelling, you probably can't move out of it and into a cheaper place without selling the old one -- a major hassle and a disaster in a down real estate market.

Industry Diversification:
If you work in an area dominated by a single industry, like Silicon Valley or Detroit or Manhattan, and you work in that single industry, real estate values in that area will fluctuate along with that industry. This means that if your industry takes a beating, you are liable to wind up long-term unemployed and needing money for relocation or retraining at the same time as the net equity in your house goes negative. Not a good position to be in.
Moving Becomes More of a Hassle:
When you move to a new place, many errands have to be taken care of, learn your way around the new city, find schools for your kids. Buying a house adds a huge decision with potentially disastrous consequences to the list of errands to be made when moving.
Too Many Constraints on a Single Decision:
A house you own has to satisfy too many requirements at once. It has to be appropriately located, the house itself has to be the kind of place you want to live in, and it has to be a very good investment. It is unlikely that you'll find a house that really meets all these requirements very well.
Prior to the Bubble Bursting

The government had an attitude that the more Americans owned their homes, the better. I remember in Bill Clinton's autobiography he spoke with pride about how the rate of home ownership increased during his presidency. This attitude is flawed -- many people are not cut out to be responsible home owners. And we have a great system for identifying who those people are, it's called the FICO credit score. People with lousy credit scores should not be given home loans, they are not responsible enough to handle it.

Another way to see if someone is going to be able to pay a mortgage is to demand a substantial down payment. If they can handle their money well enough to save up a down payment, that does a lot to demonstrate that they'll be responsible about paying back the mortgage. In addition, it provides a cushion, so that if the value of the house sinks by less than the down payment, the home owner still has positive equity in the house and is less likely to walk away from it or declare bankruptcy. But prior to the bubble bursting, many loans were being made with no down payment required.

Reasons For the Financial Crisis

Many people attribute the financial crisis to "too much greed". Baloney. A bank that isn't greedy is not a good bank. Greed is what drives the system.

The biggest issue that drove the financial crisis was that too many people, both home buyers and Wall Street investors, thought it was a fundamental law of physics that real estate prices would always rise forever. Home buyers took out many interest-only loans, a practice that makes no sense if you believe that real estate prices might fall. The financial system made loans to many people with poor credit or who otherwise showed signs of being likely to fail paying them back. The reason the financial system was willing to make these loans is that they felt it was guaranteed the value of the house would be greater than the outstanding value of the loan, even if no down payment was made, so that worst case, the value of the loan could always be recovered by foreclosure.
When real estate prices fell, all these deals fell apart. In some states, the homeowner was legally allowed to abandon their home loan if they let the bank take the house. As a result, when home prices fell, many homeowners whose houses were worth less than the outstanding loan walked away, a tactic called "rational foreclosure". With so many loans failing without sufficient collateral to cover the cost of the loan, the banks lost so much money that it caused a crisis.

The biggest mystery of this, to me, is why the people on Wall Street were so stupid. I can understand the homeowners being stupid, the guys on Wall Street had high IQ's and MBA's, and they just should have known better. One guess I have is that many of them did know better, but they were not investing their own money. The worst thing that could happen to them if there was a meltdown is they would lose their jobs in a down market. If this happened, they wouldn't be individually disgraced, since the industry as a whole went bad. And at the rate these guys were paid when times were good, they had plenty of resources with which to weather hard times.

What's Next?

Looking forward, I think people will not, within a generation, assume that owning the dwelling they live in is a sure-fire ticket to easy prosperity. Now that people know that real estate prices can go down, and down a lot, people will be much more careful about buying houses. People will buy houses because they really want to live in them for decades, and if their planning horizon is much shorter than that, they'll rent.
It could be a generation before real estate prices, in real terms, reach the highs of the summer of 2006. Several factors, which will not be repeated soon, contributed to housing values reaching those heights:

* People had not, within living memory, seen housing prices decline significantly on a nationwide basis.
* People were taking out interest-only loans, and loans with negative amortization.
* Mortgages were being extended to uncreditworthy people.
* Home loans were being made without requiring a down payment.

since none of these conditions are going to be repeated for decades, I anticipate that we will not see real estate prices reaching their 2006 peak again for decades.

How are we to invest for retirement from here on out? That's a good question. In the meltdown, all major asset classes -- real estate, stocks, bonds -- took a nosedive. People aren't going to feel safe investing in anything that's likely to deliver a good return. Hopefully people will at least diversify.

A mixture of stocks and bonds is naturally easier to diversify that a house. Even better, mutual funds or, better still, exchange-traded funds (ETF's) -- equity (stock) funds, and bond funds. Since each mutual fund spreads the money over a variety of investments, your portfolio is effectively even more diversified. Use equity funds for growth, and the bond funds for safety. And you don't have to go into debt to buy stocks and bonds.  Yes, if there's a recession, your bond funds will lose some (but probably not a lot of) value, and your equity funds will lose a lot of value, but your nest egg will always have positive worth.

One way to invest in real estate and avoid the problem of under diversification is to buy REIT's, which are funds that invests in real estate. This also avoids the hassle of having to maintain it, and also you can buy in small quantities.

Another reason people should be encouraged to invest in stocks and bonds rather than real estate is that investments in stocks and bonds help fund companies, which employ people and make stuff. Investment in real estate, for the most part, achieves no social good but rather just chases up the price of land.
I've heard the argument made that a purchase of stock only helps industry if you bought the stock directly in the IPO. This is wrong. As long as you own stock in a company, you have a relationship with that company. The shareholders can, at any time, choose to dissolve the company, sell the assetts of the company such as equipment, and return that money to the shareholders. Until they do that, they are continuing to invest in the company and their money is at work doing what the company does.

Wednesday, February 10, 2010

Movie Review: The Secret

This movie discusses the "Law of Attraction", supposedly a secret that will unlock untold and unlimited human potential.

This movie reminded me a lot of when I took "The Forum" (descended from EST), which is typical of the self-help genre, which tends to have the following characteristics:
  • Hardly any of the presentation is spent discussing the specific techniques that are supposedly going to improve your life.
  • Most of the presentation is spent vaguely praising itself. There is a lot of dramatic imagery involved.
  • A very strong pitch is made that you have the ability to completely control your life, the implication being that if you adopt the (barely discussed) techniques, everything in your life will improve.
  • The actual wisdom being imparted is actually very simple, not really enough to justify a whole movie or book, the rest is just window dressing to make it appear to be the core issue of the universe.
The "Law of Attraction" states that the universe delivers to you whatever you think about. It doesn't distinguish between good and bad. If you focus on the bad things, they will inevitably come to you. The way to make good things happen is by focusing just on those good things. That's it. That's the whole secret.
I think there is value to this. If you are focused solely on those bad things, without having positive thoughts about a way out, that's not a very constructive approach.
But I have also seen a couple of the most catastrophically failed people I've ever met who were totally following this philosophy.
  • One was a drug dealer who I knew in college. He was totally focused on how he was going to build his drug dealing business into a billion dollar corporation, and ignored the risks involved - this risks to his health caused by all the drugs he was taking, and the risks posed by the dangerous criminals he was associating with. He lost his sanity because of drug use and never really recovered.
  • Another was a guy who read some books about instant millionaires on Wall Street, who borrowed tens of thousands of dollars on credit cards to play the stock market. He did not think about the risks he was taking, and would not listen to my advice that these books he was reading were not economically sound, but just focused on the great wealth he was going to be enjoying, He had no health insurance, he drove without auto insurance. He lost his shirt in the market (by short-selling a high-tech startup, which makes absolutely no sense to any investor who takes risk into account), and last I heard was being sued by multiple banks while unemployed.
Fear is in many ways a very healthy instinct, keeping us from doing a lot of stupid things. It is a highly underrated emotion. Thinking about risks, avoiding them, and making preparations for the unavoidable ones, is very sound practice.

Another drawback of positive thinking comes to mind. I remember one time the state lottery jackpot was up to 100 million dollars. Normally I don't buy lottery tickets, but that week I bought one.
The whole week I spent a lot of time thinking about all the magnificent things I would do with 100 million dollars. At the end of the week (surprise!) I didn't win. I realized I had made a mistake in buying the ticket. The $2 lost was insignificant to me, but the wasted brain time, which could have been devoted to actually improving my life, which was instead devoted to stupid daydreams about what I would do with the money, was unacceptable. I've never bought a lottery ticket since. The human mind cannot accurately comprehend a one in a million probability, and does not allocate its time well.

There is a lot of talk about visualizing what you want, but that really is no "secret" to athletes. I remember being told in football practice to visualize myself doing the proper technique, and it is definitely a useful tactic.

But the movie makes claims that the supernatural is behind this principal. One guy in the movie claimed to "create" parking spaces for himself by visualizing them ahead of time. If "the secret" really works, I'd want a lot more than parking spaces from it -- I'm reminded of the time Homer Simpson got any wish he wanted and he asked for a really nice sandwich.

The movie talks a lot about sickness. There are always miracle cures occurring - a certain fraction of cancers just go away by themselves, and sometimes people heal when the doctors gave them no hope. For this movie, they dug up some of these people who then claim it was all done with the power of their minds.
I am reminded of a study discussed in a psychology class I took in college. Periodically, wildfires approach suburbs in Southern California, and sometimes they burn down some of the houses. People take numerous measures to save their houses - they stand on the roof with water hoses putting out burning embers than land on them, they run around the yard stomping out the flames. So for this study, they went around the neighborhood taking a survey of what measures were taken to save houses, then studied the correlation between measures taken and house survival. They found no correlation. What people did to save their houses made no difference. In the survey, they also asked people if the measures taken influenced saving their houses. The people whose houses survived tended to think their measures helped. The people whose houses burned down felt there was nothing that could have been done.
I am reminded of hearing about how people would be told in EST seminars that they are responsible for having gotten cancer, and this movie is doing exactly that. If the sick person actually listens to this drivel, their suffering is compounded by feeling guilty for having brought this upon themselves.
Furthermore, people may shun surgery and medication and try to just think themselves healthy. Interestingly, the movie offers no actual studies of survival rates of people who turn to modern medicine as compared to those who adopt a program of positive thinking according to the dictates of the Law of Attraction. But this movie isn't really addressed to the type of people who ask for statistics. Like most quack medicine, the focus is all on testimonials rather than studies.

They claim that The Secret has been passed down through the ages, in secret. What is not made clear is If this were true, Why was it kept secret? The movie specifically states there would be no ill effects if everyone embraced The Secret, there is enough abundance to go around. So the more people knew this, the better. There would be no reason for a few giants to hoard this wisdom and shut out the majority of the human race. There is also no specifics of the history of this secret through the ages, no specific examples of anyone trying to suppress anything.