Many households concentrate most of their investment capacity in a single asset: their home. Such a lack of diversification has often been considered financially risky. But a recent study by Sebastien Betermier, a finance researcher at McGill University, challenges this conventional wisdom.
Diversification is the ultimate tool for managing financial risk. An investor who owns stocks in different industries and countries—in addition to bonds and real estate—is less likely to lose it all than someone who invests everything in a single asset.
However, the cost of homes is so high now that most households are forced to “concentrate” a large share of their wealth in becoming homeowners. Yet many are willing to take that risk. Sebastien Betermier wanted to understand what lies behind this choice.
He and his team combined a theoretical economic model of investment decisions with empirical analysis of US data on more than 2,000 households. The results indicate that one of the reasons households choose to invest heavily in real estate is that, for them, it is a risk-free asset.
Indeed, once purchased, homeowners can live in their homes for the rest of their lives, if they so choose. A home offers the opportunity to build a life within its walls, while remaining relatively immune to the fluctuations of the real estate market, stock markets and inflation. Whether property values go up or down doesn’t have much of an impact on homeowners, unless they want to sell their home. The risk-free benefits of homeowning are therefore much more important than its negative effect on the diversification of the investment portfolio.