The countercyclical asset, a continuing series, revisited

Many of you like this series and I am no longer puzzled as to why.  The countercyclical assets in recent times are A and B and best of all C.

Taser

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Soup, whores, and tasers.

kind of like apple pie, mom, and guns.

Is America a great country or what!

I'm long pitchforks and torches.

I give prizes to the lot of you commenting before me, those are perhaps the funniest comments we've had all year...!

Somehow, Playboy's stock manages to underperform.

"Intuitively, I'd have expected prostitution to be hurt by being a relative luxury good in comparison to porn. On the other hand,..."

The relative appeal of prostitution is that there is an other hand.

On a serious note, this is not really a countercyclical asset, but it is for most people the best way to weather the bad parts of a cycle, to reduce the risk; it's owning your own home free and clear, or having a very high percentage of equity.

With your home paid for, with no mortgage, your monthly expenses are much lower, so if, for example, you're laid off during a recession, it's much more likely you'll be able to get by until you find another job without resorting to drawing down your savings, or without resorting to debt which can spiral out of control.

If your (hopefully well diversified) stock portfolio drops in value during a down cycle, at least you have the security of a fully paid for nice home, so even with lower stock income you can usually still live well.

Of course, you still have to pay property taxes, maintanance, and utilities, so even with no mortgage you don't want the home to be too large or expensive. The key idea is that a great way to reduce risk in today's far riskier world is to keep your fixed expenses low, at least under 50% of your after tax income, then you have a lot of room to cut back to temporarily weather crises. This is the advice of Harvard professor Elizabeth Warren in her book, "All Your Worth: The Ultimate Lifetime Money Plan", which I think is by far the best personal finance book today.

Now you may say it's bad to pay off your mortgage because you lose the mortgage interest tax deduction, but still, even considering that, paying off your mortgage is typically just as good as, or better than, investing money in government bonds. Why? When you pay off a typical mortgage you are saving about 6% in interest on the amount borrowed, but you lose a tax deduction. If your marginal tax rate is 30%, then you would have gotten back 1.8% of that interest in tax savings, so your effective interest rate would have been 4.2%.

Now, what if instead, you didn't pay off your mortgage, and as an alternative to reduce your financial riskiness you purchased government bonds paying 5%? In this case you would not effectively get 5% because you would pay income tax on the interest. At that same marginal tax rate of 30%, you would pay 1.5 of the 5% in taxes, so your effective interest rate from the government bonds is 3.5%, which is less than the 4.2% you'd save from paying off your mortgage.

Moreover, owning your own home is a fantastic hedge against inflation, better than CPI-linked bonds because the CPI is based on price increases in a basket of goods that may be quite different from what you consume, while your own home is a huge part of what you consume. Plus, after taxes, CPI bonds can pay less than the inflation rate, but with your (primary) home, there are no taxes on any price appreciation.

So, paying off your home really is a great way to reduce your risk of anything. Just be careful not to purchase a home so expensive that it pushes your fixed expenses beyond 50%, and unless you are going to not move for at least 3 years it doesn't make financial sense to buy a home; the selling costs (including large time costs) will swamp the typical price appreciation.

What Slocum said.

Or accomplish the same thing by renting a really cheap place. Then you don't have a whole bunch of money tied up in a risky asset.

Or live on a sailboat in the Bahamas, as I do. It's not terribly roomy, but warm and cheap, and you can't beat the view!

Slocum, I didn't mean paying off your home should be your only form of saving, but it can be a very important part of your asset portfolio. During non-bubbled times (so not now; homes are still substantially overpriced), it makes financial sense to buy rather than rent an equivalent home if you will not be moving for a while, clearly if you will be staying put for 10 or more years.

As you get older, and when you otherwise face more risk, it makes sense to add more very safe assets to your portfolio, like government fixed or inflation adjusted bonds, but paying your mortgage off will usually yield a higher after-tax return than these. In addition, paying off your home can give you substantial protection in bankruptcy. Although I believe all states should let you keep home equity up to at least the median price in your area, with sensible restrictions, it's still the case today that 17 states let you keep $50,000 or more, with large states like Texas and Florida letting you keep an unlimited amount. No one wants to think about bankruptcy, but in today's far riskier world most people have to. About 1 in 70 families declare bankruptcy each year. The rate went from 1/278 in 1981 to 1/71 in 2004.

In addition, owning you own home, as I said, is a better inflation hedge than inflation indexed bonds because all of the interest on those bonds, the inflation part and the real return part are taxed, while capital gains on your primary residence are not taxed up to $500,000 for a couple.

As an example, if inflation went to 7%, and the real (pre-tax) return on a TIPs bond was 2%, you would be taxed on the whole 9%. If you were in the 30% tax bracket, then you would collect an after tax return of 5.6%, which is 1.4% less than the inflation rate.

Plus, your home is exactly in your basket of goods, but the CPI basket may not fit what you consume that well.

Really it depends on your situation, but as an example like I was thinking when I first posted, if you have $800,000 in savings and a $250,000 home with a $200,000 mortgage, and you face the typical risks of a middle-aged family man today, it probably is a good idea to pay off your home, as well as any car notes.

sink money into a depreciating asset.

Depending on inflation and real interest rate, life of asset and length of loan, isn't the usual best approach to pay cash rather than borrow for depreciating assets (like cars) and borrow/leverage for appreciating assets (like houses used to be)?

When I was a teenager in the 60s, it dawned on me how much life had changed when several friends mentioned that their grandparents had paid cash for their homes (pre-1930s), and now (in the 60s) everyone had mortgages. The expansion of credit to more of the population than just the very wealthy has been in some measure responsible for the dramatic increase in the standard of living we enjoy. (See, e.g., Frank Capra's "It's a Wonderful Life" (1946).)

Now it appears that the dramatic expansion of easy credit in the form of low down/no doc mortgages may be responsible for the reduction in our standard of living.

Yeah meter, I was just saying in general, often paying off ones home is a good idea. If you don't already own a home, now is not a good time to buy one. Home prices are still substantially above their historical trend level, and there's good reason to think they will sink to that level at least. But if you already own a home, have a mortgage, and can't practically sell the home and move, then there are strong benefits to paying off the mortgage.

It seems we will be in economy ression for quite a long time. We can see the economy crisis effect everywhere.

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