Is your house an asset?

Opinion is divided on whether your house is an asset based on who you ask. Some financial planners recommend that you make your investment plan first, save for a house, buy it only when the rent vs buy equation makes complete sense, and treat the monthly payment as a pure expense (after accounting for tax deductions). Some others say that a house is an investment, and even better than stocks as it is not risky and volatile, and you generally will not lose your money there.

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Like most matters in finance, there is no single answer – but here is an attempt to simplify the thought process. In pure accounting terms, a house is an asset on your books, funded partly by the loan liability. The real question that should be asked is whether it is a good investment? In most cases, it turns out to be a good investment, simply because the asset on your books appreciates faster than both the cost of your liability and inflation. But whether it really happens at a rate where it qualifies as a good investment depends on a multiple set of factors.

(a) Price that you paid for it: Like economic cycles, housing goes through boom and bust cycles, though not as severe as stocks. Hence, the price at which you buy a house is paramount, like all other investments, in deciding whether it will turn out to be a good investment. As it is a high value asset that most people hold for a long time, most people pay much more attention to the price they pay for a house, versus what they pay for a stock. But nevertheless, it is still the single most important factor in determining if it will turn out to be a good investment.

(b) Loan to Value ratio: Leverage (or mortgage) has a definite role to play in the house purchase. The higher the loan component, the higher the chances that the investment will be not be lucrative in a short period of time. The more you can put down in payment, the more (and earlier) you are converting your cash into a share in an asset that will eventually fight inflation.

(c) Your cost of funding versus inflation or expected rate of growth: If the expected rate of return from a house is about 1-2% more than the rate of inflation, and the cost of funding is lower, that is a perfect scenario where buying a house using borrowed funds will turn out to be a good investment. Specially over longer periods where the power of compounded asset value will surpass the cost of the loan liability.  And if one regularly prepays it in the initial stages, one will save lots of interest in the long run.

(d) Last but not the least, where does it fit in your asset allocation: Finally, as compared to your income and net worth, the proportion that you have locked in a house will also determine how comfortable you are with buying the house, the more likely it is that you will take a financially sound decision, hence increasing its chances of working out as an investment.

So overall, multiple factors will go into deciding whether a house will turn out to be a good investment. In a best case scenario, buying a house at a reasonable price with less than 75% leverage at a leverage cost less than or close to inflation, and ensuring that it does not account for more than 40% of assets is almost a sure-shot recipe for a house being a great investment. For most mortals, it may not turn out to be that rosy – in which case one or more of these parameters are likely to get stretched, leading to some financial bleeding, at least for a while.

In general, irrespective of the pure financial matters and even discounting the emotional security it provides, a house is definitely likely to be a worthwhile investment for most normal individual investors if they are prudent in ensuring they balance the above factors in their purchase. As most house purchases are held for long periods, they invariably turn out to be good investments standalone.  They may lead to some missed opportunities due to locked capital, but that’s another matter. After all, I never saw a house owner of 10 years saying I really regret having bought my house. And there’s no dearth of stock owners saying that!

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Is direct stock investing worth it or should mutual funds do?

Assuming that I want to “invest” in the stock market, and not “trade” or “speculate”, getting average market returns is a no-brainer. I just need to buy an open-ended index fund or an exchange traded index fund, and I am done. At the lowest cost, I am guaranteed returns that the market index will give – day on day, month on month, year on year.

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Why, then, should I be even interested in investing in actively managed mutual funds? There can be only a few reasons for that. First – they give returns better than the index after deducing costs.  Second – I want an exposure to companies outside the index in a specific market cap or sector or style that I am bullish about. So it may make sense to supplement my index fund holdings by some actively managed funds that suit these requirements.

After that, why should I directly invest in stocks? Is it really worth the time and effort? There are few reasons when it may make sense. First – I am a better investor and can beat markets consistently. Easier said than done, but if that is the case, there is no reason I need to invest through the fund route. It is likely to take sufficient time and effort, but if indeed one can beat the index, why depend on mutual funds? Second – I want to invest in some businesses that are either small or in under-researched sectors that funds are not allowed to, or not able to invest in. There is a section of the market that institutions are not interested in. An individual investor who understands those businesses and has conviction on a particular company, has an advantage by investing directly. Third – this is perhaps due to the structural constraints of mutual funds. Due to the inherent requirement of funds to keep beating the index, some great businesses cannot be held by funds for long periods of time. For example, a mid-cap fund has identified a great mid-cap company, but once it becomes successful and actually becomes large-cap, the fund has to sell it. Or, during a market crash, a fund has to sell some companies to honor redemptions – so a buy and hold is not possible, even in case of great businesses.

In such scenarios, it may be worth it for individual investors to invest directly in stocks instead of the mutual fund route. But as index returns are easy to get, one has to be sure that these additional investments will actually help better portfolio returns rather than dilute them. Therefore, overall – allotting majority of your equity allocation to mutual funds (index or active based on performance) might be a prudent strategy for individual investors. Investments through direct stock holding can be a small part of your equity allocation – only in situations where there are valid reasons for the same.

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