Wall Street shows the way, part 2: "investor risk".

Wall Street shows the way, part 2: "investor risk".

In part 1, we saw how Wall Street uses an apparently innocent "investor questionnaire" to educate its clients on their tolerance for risk. Think you're a rootin' tootin' no-fear investor? Maybe so, but Wall Street doubts it and, if you're honest, you may too once you finish the questionnaire.

Last week I wondered whether the real estate industry might benefit from a similar questionnaire, reworded for that market, and offered a few sample questions. This week we'll continue that thought, but with an emphasis on what the Street calls "investor risk".

Continuing with the questionnaire, you're asked how much a market downturn would affect your sleep. Great question given that downturns have been known to happen in both the stock and real estate markets. In fact, "renters by choice" cite the cyclical nature of real estate as a good reason to be wary of homeownership. Because as we all know, real estate bites you in the rear. Nope, just sock your money away in that dead reliable stock market and watch it grow grow GROW!

Yes yes YES!

Except this decade which, according to a December 20, 2009 WSJ article, is "likely to be [the stock market's] worst...ever". Yes, friends, "in nearly 200 years of recorded stock-market history, no calendar decade has seen such a dismal performance as the 2000s. Investors would have been better off investing in pretty much anything else, from bonds to gold or even just stuffing money under a mattress [or—shudder—buying a house?]. Since the end of 1999, stocks traded on the New York Stock Exchange have lost an average of 0.5% a year thanks to the twin bear markets this decade."

Fun stuff! No wonder noted portfolio manager Mario Gabelli calls them the "Terrible 2000s"! No wonder Wall Street is curious to know how you'll handle yourself when your retirement savings are cut in half! And in case you're tempted, jumping out the window is so 1929!

!!!

And, just for reference, in February 2000 Palo Alto homes were selling for an average of $669 per sq.ft. In February 2010 they sold for $799 per sq.ft., for an average annual rate of return of almost 2%, which, most of us will agree, is better than -.5%. But yeah, I know, soon they'll be selling for a handful of bottle caps per sq.ft.

Okay, now that I got that off my chest, let's get back to the fun stuff, which winds down with an "investor style questionnaire", ten questions you answer with a range from 1 ("completely disagree") to 10 ("completely agree"). Not all the questions translate to real estate, but a few do.

For example, "Investing intimidates me." I give this a 5, because I know I don't know what I'm doing in the stock market, and that should intimidate me, but this is balanced by lots of faith—maybe too much faith—in the stock market. For real estate purposes, this statement could be changed to "buying a home intimidates me" or "selling my home intimidates me" and, based on my observations, any buyer or seller who doesn't give this a 10 is either kidding himself or a former Navy SEAL.

Here's another: "I love the excitement of trading or investing." This gets a 1 from me, because I've never been tempted to start day-trading. Give "I love the excitement of going to open houses" or "I love the excitement of getting into contract and then bailing" a 10 and I'll thank you for the warning.

"I follow the stock market on a regular basis." Years go by without me making a deliberate effort to check the S&P 500, even though a good part of my net worth is in the stock market. Which I find ironic, given that the average bubblehead, not invested at all in real estate, would give "I follow the real estate market obsessively (even though I don't know what I'm following)" a 10. That same bubblehead would, paradoxically, also give "the real estate market is too risky for me" a 10.

But as I say, this is just the fun stuff, although it's not in fun, because I'm pretty sure that Wall Street knows the liability-repelling magic of my answers. If I tell my brokerage, in writing, that I'm a gung-ho pedal-to-the-metal risk-loving investing son of a gun, even if I only think I am, I can't come back years later and sue it for getting me into gung-ho pedal-to-the-metal risky investments.

Finally, let's leave the investor questionnaire and move to your mutual fund's prospectus which, as you've noticed, has a section warning you of the risks it offers investors. The type and number of "investor risks" varies from fund to fund, depending on how complex its investment strategy is, what it trades in and where it trades. Here's one of the shorter lists I've seen, from a Vanguard fund:

stock market risk: the chance that stock prices will decline
investment style risk: the chance that returns for the types of stocks in which the Fund invests will trail returns from the overall market
manager risk: the chance that poor security selection...will cause the Fund to underperform

You can see the parallels to the real estate market.

housing market risk: the chance that home prices will decline. You might think this was a no-brainer, but I'm told on excellent authority that some loan agents were instructed to tell their clients that "home prices never go down in California".
housing type risk: the chance that prices for certain types of housing will trail returns from the overall housing market. I hesitate to bring this up, because I don't want to encourage the kind of "where's the best place to put my money?" speculation that ties buyers up in knots and seems inevitably to lead to sure-fire bets that are anything but. Buy what you can afford, where you can afford it, and where you'd enjoy living even if prices went down. Now, it's true that the condo market in this area cooled first and has yet to warm up. But if you have your heart set on living, say, in downtown Palo Alto, and condos are what you can afford there, then the choice you have isn't between different types of housing stock, it's between buying and renting. Don't plunk your Palo Alto condo money into a palatial single-family home in a Central California retirement community you can't move into for thirty years.
"working all the angles" risk: the chance, for example, that the "under-priced gem" you picked up cheap during the boom because it's on a busy street will lose even more value than other homes in a bust.

Or here's another variation on "manager risk": the chance that poor home maintenance and remodeling choices may decrease the value of your home. I know of one homeowner who regularly pays contractors to do things to his house that are just more things for the next owner to rip out and haul to the dump.

So there you have it, Wall Street's lessons for the real estate industry. And if you spend an extra half hour filling out a "homebuyer questionnaire" the next time you write an offer, you'll know who to thank.