Don't Forget Home Equity

For most people, home equity is a large part of total wealth. Yet asset allocation plans -- which try to formulate the ideal mix of stocks, bonds, and other investments -- often fail to take this asset into account. Dean Gatzlaff, a professor of business administration at Florida State University's College of Business in Tallahassee, has developed a method to do just that. Associate Editor Anne Tergesen spoke with Gatzlaff by phone.

Why include home equity in an asset allocation plan?

Investors should attempt to maximize their overall net worths -- not simply the value of their financial portfolios. To do this, you need to consider the value of all your assets. In theory, this would include your cars, artwork, jewelry, collectibles, and more. More practically, this means treating home equity as another asset that diversifies a portfolio. Including home equity in an asset allocation mix modifies the optimal allocation to stocks and bonds.

Why is real estate a valuable addition to a portfolio?

It tends to behave differently than stocks and bonds. For example, while real estate does well in times of inflation, stocks and bonds often do not. So, by adding real estate to a portfolio, it's possible to lower risk and still achieve the same return.

How much should people ideally hold in stocks, bonds, and home equity?

The answer depends on a number of factors. For a homeowner with a mortgage covering about one half of his home's value -- that's close to the national average -- the answer is to have 40% to 45% of net worth in home equity, with the remaining portion split 60%-40% between stocks and bonds, respectively. That allocation assumes you're aiming for an 8% average annual return for your entire portfolio.

Many homeowners are close to that 40%-to-45% target. Nationwide, home equity represents just over 40% of median net worth.

What if you have a large mortgage relative to your home's value?

As a rule of thumb, if you start with the allocation I just outlined, for every $1 your mortgage rises above one-half of your home's value, you should increase your bond allocation by 75 cents and your stock allocation by 25 cents. So if you have a $500,000 home and increase your mortgage from $250,000 to $350,000, you should ideally allocate $75,000 of the proceeds to bonds and $25,000 to stocks.

The reason I recommend this is that as your mortgage rises, you are taking on more risk as a debtor. You offset that risk by buying more bonds, which makes you a creditor.

What if your mortgage is below half your home's value?

The relationship also holds in reverse, so for every $1 your mortgage falls below one-half of your home's value, you should decrease your allocation to bonds by 75 cents. If you have no mortgage and are aiming for an 8% return, an ideal allocation would be 10% bonds, 30% home equity, and 60% stocks.

Are real estate investment trusts (REITs) a good substitute for home equity?

REITs are backed by the real estate they hold. But they're also stocks, and money flows in and out of them a lot differently than it does with directly held real estate. As a result, REITs generally behave more like small-cap stocks than like real estate. So you don't get the same kind diversification benefit from REITs.

As your wealth increases, you should diversify your real estate holdings to include income-producing properties as well as your housing. Of course, if you have a pension, you may already have exposure to commercial property, since many pension funds put about 5% of their money into real estate.

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