Home Equity

[kidsgone]

My Wife and I are within one year of retirement, and recently moved across county and paid cash (from our taxable account) for a home. Our overall AA was and remains at 50/50 since we recently shifted some stock into bonds and TIPS (all three in tax deferred accounts) to keep our AA in line after taking out cash for the home. My question: should we consider some of the home equity as part of our fixed dollar amount when looking at our 50/50 AA? If yes, than I assume that we would have to add more stocks.

[Call_Me_Op]

Your primary residence should not be considered part of your investment portfolio, IMO.

[NoVa Lurker]

Congrats on buying a home with cash from taxable!

This is an old and somewhat "agree-to-disagree" debate, but for what it's worth I take the opposite view of Call_Me_Op. Since you can sell your home and rent, I do not see the point of completely excluding home equity from an AA calculation. Instead, I take a very, very low estimate of the value of the home, subtract the estimated transaction costs of moving (including realtor costs, other closing costs, any taxes, and moving expenses), and of course subtract any debt on the property. The remainder is a conservative estimate of home equity for purposes of asset allocation.

Every six months, I revise the net valuation based on recent market comps/fluctuations (and based on the remaining principal on our mortgage). I recognize our house is much less liquid than index funds, but it still has value.

[Beantown85]

How does the value of your home compare to your total NW? If it's a smallish percentage, I would definitely ignore it. If it's 50% of your total NW (for example), it may be wiser to include it at some discounted rate, as Nova mentioned.

[Harold]

Ultimately it doesn't matter as long as the amount of risk you can tolerate is calibrated correctly. That is, if the home is included the stock allocation should be less than if the home is excluded. (In other words, buying a home doesn't magically make you able to tolerate more risk.)

Most forum participants would probably suggest that you exclude the home from the asset allocation. (But most forum participants would say you get to mortgage your home and use the cash to buy assets included in the asset allocation -- Bogleheads are a confused lot.)

[Call_Me_Op]

Since you can sell your home and rent, I do not see the point of completely excluding home equity from an AA calculation.

But practically speaking, how many people are going to do that? It is very inconvenient, to say the least. I prefer the model of living in my home and having an investment portfolio that will eventually pay my expenses - a portfolio I can conveniently rebalance to control my risk.

[ks289]

This is a tough question which has been debated on this forum for years.
I see good arguments on both sides for including/excluding home equity from AA. My own opinion and practice has been to exclude home equity from my AA, but I find the whole inclusion (mortgage as negative bond) argument very interesting. There are some (a Businessweek article from years ago mentioned this) who advocate having a certain percentage (40%-45%) of net worth in home equity for optimal risk/return for an overall portfolio.
My own % of net worth in home equity is something I rarely consider or calculate, but it has dropped in recent years as I save/invest over paying down mortgage, but I agree with those who might consider that very aggressive.

[NoVa Lurker]

Since you can sell your home and rent, I do not see the point of completely excluding home equity from an AA calculation.

But practically speaking, how many people are going to do that? It is very inconvenient, to say the least. I prefer the model of living in my home and having an investment portfolio that will eventually pay my expenses - a portfolio I can conveniently rebalance to control my risk.

I definitely see your point, and I think the majority (maybe 65%? 70%?) of Bogleheads agree with your view. But when I saw this thread, yours was the only reply, so I just wanted to make OP aware that not everybody takes the same view, and that there is an argument for including home equity to some extent. I agree people are unlikely to sell their home and rent in order to rebalance, but if you have a paid-off home and needed cash, you could: (1) sell it and move to a smaller home, (2) get a mortgage, or (3) sell it and rent / eventually move to assisted living, etc. Those would all involve transaction costs and might not be ideal - but taking the opposite view and ignoring home equity just doesn't make sense to me. If I use cash to pay down principal on a mortgage, I'm not losing an asset, I'm just trading one asset for another.

Ultimately, I agree with Harold and ks289 that figuring out your rough risk tolerance is the important thing. We're all just ballparking (50/50 vs. 60/40? who knows?) anyway.