I’m not sure if homebuyers truly realize how much concentrated risk they are taking when they buy property. Most middle-class homeowners have a majority of their net worth in their primary residence. This can be dangerous during a downturn. Therefore, I want to use this post to discuss the main types of investment risk exposure to be aware of.
Investment Risk Exposure
‘m particularly concerned about first time buyers putting less than 20% down because they can’t afford a larger downpayment. Given they can’t put at least 20% down, it’s likely they also don’t have any meaningful investments in stocks, bonds, or private ventures. In other words, they are all-in and then some with real estate. Always follow my 30/30/3 home buying rule.
Just in case it’s not obvious, mortgage debt is also considered investment risk exposure. You’re basically leveraging up to make a concentrated bet on a single asset that hopefully goes up. If it goes down and you need to sell, you’re screwed. During the last downturn in 2008-2009, the average American’s net worth got destroyed because over 80% of the average American’s net worth was in real estate.
Some people have asked why I wasn’t in a bigger rush to reinvest 100% of my house sale proceeds (~$1.8M) in this bull market. If I did, I’d still have $815,000 less in risk exposure because I paid off the mortgage.
The first reason why I wasn’t in a rush to reinvest the proceeds is because it was a lot of money. I don’t want to lose it. I redeployed about 60% over the first three months ad took another five months to redeploy the rest.
The second reason is because I needed firepower just in case I found a sweet property deal during the winter. I didn’t, but you just never know when opportunities show up. For example, during the height of the lockdowns in April 2020, I found a sweet ocean-view property in San Francisco for a $200,000 discount.
The final reason why I didn’t rush to reinvest is because I still had roughly $1,000,000 in mortgage debt. Meaning that with a current cash balance of ~$900,000, I’ve already got Maximum Exposure + $100,000 in leverage to risk assets.
The Definition Of Maximum Investment Risk Exposure
Maximum Exposure is not just investing everything you have in risk assets like stocks and real estate. Having Maximum Exposure is investing everything you have in risk assets AND borrowing as much as possible to also invest in risk assets.
With real estate, banks will generally lend your household up to 5X your annual household gross income. With stocks, brokerage accounts may let you borrow up to 50% the value of your stock holdings in the form of margin.
For the record, I’m not a fan of going on margin buying stocks or taking a HELOC out to buy risk assets. Stocks are much more risky than real estate. Stock value can lose 30%+ over night. Whereas real state is much more stable.
When To Have Maximum Risk Exposure
The time to have Maximum Exposure to risk assets is when there is blood in the streets. That time period was most recently between 2009 – 2010. The problem is that nobody can properly time their Maximum Exposure to perfection. It can only be done in hindsight.
Given perfect timing is impossible, one must raise and lower their exposure during a cycle. The long term trend is luckily up and to the right. But the desire or ability to work is finite, and so is life itself. There’s no point dying with boatloads of money, especially if it’s going to be taxed at 40%.
I did a reasonably good job getting Maximum Exposure from 2003 – 2007 with investments in stocks and two San Francisco properties and one Lake Tahoe property. Total mortgage indebtedness was roughly $2,200,000 as a 27 – 30 year old. Then I went backwards for several years until the market started stabilizing in 2010, and ultimately recovering.
I wanted to de-risk by $1.1M in 2012 because I had just left my job, but nobody wanted to buy my property at the asking price. By the time 2014 rolled around, a 4.1% CD came due and I had the fire power to buy another property to gain Maximum Exposure again.
It’s strange how quickly my mindset changed from de-risking to increasing risk in two years, but I decided to take on $1,000,000 more in debt to buy a fixer in Golden Gate Heights because my online revenue was growing, my net worth had rebounded, and I strongly believed buying a panoramic ocean view home on both levels for $720/sqft was a no brainer.
The Definition Of Full Investment Risk Exposure
After selling my rental house, I reduced my investment risk exposure to Full Exposure. At the time, this is exactly what I wanted after a ~60% rise in San Francisco property prices since 2012, an ~82% rise in the S&P 500 since 2012, and a ~130% rise in the NASDAQ during the same time period. Further, given my site’s size and the fact that I’m still a one man band who now has fatherly responsibilities, I’m expecting online revenue growth to slow.
Full Exposure is defined as investing all your cash flow and having all your assets tied up in risk assets plus a comfortable buffer. The comfortable buffer is up to each individual. Six to twelve months worth of living expenses is appropriate. For me, I like to have at least $100,000 in cash for emergencies or investment opportunities.
Full exposure also requires one not be leveraged to a risk asset, or have cash equal to the amount of mortgage or margin exposure. Given I have about the same amount of mortgage debt and cash, I’ll further refine my definition and describe my exposure as Synthetic Full Exposure. Synthetic Full Exposure is less risky than Full Exposure due to having a large cash balance.
Because I’m not sure how long the bull market will last, I’m concurrently paying down mortgage debt and investing in stocks, bonds, and cheaper real estate investments around the country each month. The goal is that by the time a bear market arrives, I’ll have less debt, additional gains in risk assets to buffer for a downturn, and plenty of cash to take advantage if things get really ugly.
The Definition Of Reduced Investment Risk Exposure
I define Reduced Exposure as investing less than 70% of your regular after tax, after all expenses income and having more than 30% of your net worth in risk-free assets like cash, CDs, treasuries, and municipal bonds. Reduced Exposure is great leading up to a bear market and for at least the first year of a bear market. Eventually, you’ll want to switch from reduced exposure to Full Exposure once there are indications that the bear market has bottomed.
Again, it’s impossible to perfectly time the market. Therefore, it’s important to do your best to manage your risk exposure at various points of the cycle. It’s not bad to sell a little too soon or buy a little too early. You don’t want to be selling when everyone is selling, nor do you want to buy when everyone is buying. The herd mentality destroys pricing rationality.
I’m not in Reduced Exposure mode yet because corporate earnings are rebounding, interest rates remain low, and the government and the Fed is being as accommodative as possible post-pandemic. Although it does feel like 2007 again. It also feels like the party could continue for a couple more years.
Little-To-No Exposure = Investing FOMO
You can have little-to-no exposure to risk assets, but that type of exposure will likely leave you bitter at life if you are not already financially independent because you’ll have to work forever or experience endless envy towards those who bought a home or made a fortune in stocks or other risk assets.
Read any real estate section in any major city newspaper and you’ll feel the angst of the writer talking about how unaffordable prices are. The same goes for the stock market section where journalists regularly make fun of the meteoric rise in certain stocks and cryptocurrencies. You can bet your bottom dollar all the authors have been left behind.
Don’t get left behind.
In 20-40 years, your children will ask you why you didn’t take advantage of today’s low prices. We all wish our parent’s bought as much ocean front property and unhealthy McDonald’s stock when they were young. My grandfather could have bought beach front land in Waikiki during the 40s for nothing, but he didn’t want to be next to a butcher. Darn it.
Take Some Calculated Risks
After you achieve your stretch net worth goal, you can’t help but want to run up the score even more in a bull market. One reason why is because you know the bad times will eventually come again and you want as big of a buffer as possible. Another reason is simply because you can afford to take risk with money you didn’t think you’d ever obtain.
To achieve financial freedom, more than half the battle is to simply have appropriate risk exposure for as long as possible. The exact type of exposure you have is secondary. Here’s my recommended net worth allocation by age and work experience.
My hope is that everyone who reaches their stretch net worth goal uses the money to buy themselves time. Time is always running out. Money is infinite.
Real Estate Investing For Desirable Risk Exposure
Real estate is my favorite way to achieving financial freedom because it is a tangible asset that is less volatile, provides utility, and generates income. Stocks are fine, but stock yields are low and stocks are much more volatile. The -32% decline in March 2020 was the latest example. However, real estate held steady and appreciated in value then.
I believe real estate provides the best combination of returns, lower volatility, and desirable risk exposure. Take a look at my two favorite real estate crowdfunding platforms that are free to sign up and explore:
Fundrise: A way for accredited and non-accredited investors to diversify into real estate through private eFunds. Fundrise has been around since 2012 and has consistently generated steady returns, no matter what the stock market is doing.
CrowdStreet: A way for accredited investors to invest in individual real estate opportunities mostly in 18-hour cities. 18-hour cities are secondary cities with lower valuations, higher rental yields, and potentially higher growth due to job growth and demographic trends.
I’ve personally invested $810,000 in real estate crowdfunding across 18 projects to take advantage of lower valuations in the heartland of America. My real estate investments account for roughly 50% of my current passive income of ~$300,000.
Recommendation To Build Wealth
Sign up for Personal Capital, the web’s #1 free wealth management tool to get a better handle on your finances. In addition to better money oversight, run your investments through their award-winning Investment Checkup tool to see exactly how much you are paying in fees. I was paying $1,700 a year in fees I had no idea I was paying.
After you link all your accounts, use their Retirement Planning calculator that pulls your real data to give you as pure an estimation of your financial future as possible using Monte Carlo simulation algorithms. Definitely run your numbers to see how you’re doing. I’ve been using Personal Capital since 2012 and have seen my net worth skyrocket during this time thanks to better money management.