Money Management, Personal Finance

The Importance of Diversification: You Need More Assets

by Jeremiah Kopp
January 28, 2021
JD/MBA - Articling Student
January 28, 2021

Part 3: Why You May Want to Hold Off on Buying Your Home

The Importance of Diversification: You Need More Assets

Introduction: The Importance of Diversification

For many Canadians, purchasing a home is regarded as an important step towards securing a stable financial future. Everyone has had a friend or relative say, “Why would you pay down someone else’s mortgage when you can pay your own?” That kind of advice may be commonplace, but is it true? Is buying a home actually a smart investment? In reality, while homeownership can certainly provide a sense of personal pride and stability, many people would be better off if they rented for longer – as much fun as it is to browse for properties online, holding off on buying your dream home may just be the best financial decision that you ever make. Understanding the importance of diversification is critical to ensuring you are maximizing your financial position.

In Part 1, we covered why homeownership may cost more than you think. In Part 2, we explained how to make your mortgage tax-deductible. Now, we consider “diversification” – one of the most important aspects of building a stable financial future.

What is Diversification?

Diversification means holding a wide variety of assets such as equities, bonds, cash, and yes, real estate. The point of diversification is to enjoy the benefits of investing while protecting yourself from its risks. Investing in many different assets provides a hedge in case one of your assets declines in value or an income stream becomes impinged. For example, if the stock market declines, investing in fixed-income assets can cushion the blow because they can pay you regularly and appreciate during periods of uncertainty. Diversification is also important within each asset class. If you own stock in a single company and it crashes, you might be out of luck. However, if you own stock in hundreds of different companies through a diversified fund and a few do poorly, you will not lose any sleep.

Because of its central importance to investing, famed economist and Nobel Prize winner Harry Makowitz once called diversification “the only free lunch in finance.” Unfortunately, Canadians are largely undiversified, and their equity is disproportionately tied up in a single asset – their home.

Diversifying Beyond Real Estate

There are certain financial benefits to buying a home, of course. You cannot check its value as easily as an investment portfolio or sell it on a whim, which protects against emotional decision-making. Also, for those who struggle with staying on budget, buying a home can force you to build equity where you otherwise would not. However, there can be serious consequences in failing to diversify and investing solely (or even disproportionately) in real estate.

  • Changes in real estate value: Many economic factors affect the price of real estate, and it is important to protect yourself in case your home value declines. Yes, Canadian housing prices have generally increased over the past two decades, but there is no guarantee that this trend will continue forever. Most people will be able to withstand fluctuations in pricing if they live in their home in the long term. However, if you must sell your home and are caught in a bad market, your equity can be severely impacted.
  • Illiquidity: If you want to buy or sell a home, there are significant transaction costs and time delays that may prevent you from closing the transaction quickly. This can prevent emotional decision-making, but it also makes it harder to take advantage of market opportunities. Contrast this with equities, for example, where investments can be made with the click of a mouse and where transaction costs are immaterial.
  • Lack of investment income: Living in your home does not produce any financial return until the property is sold – if the property appreciates in value. Moreover, many people will simply buy another property when selling their existing home rather than transitioning to a rental or downsizing. Because the equity in real estate often stays locked inside of a home and does not produce regular income, people may miss out on income that can otherwise be cultivated by investing in a balanced and diversified portfolio.

Some people may be able to buy a home and build diversified investment portfolios – but most Canadians do not. The national household saving rate has been in decline since the 1980s, and people have generally saved less than 5% of their income per year since the mid-90s. Why? There are many factors, but a big reason is homeownership. Even though interest rates have plummeted since the 90s, the cost of real estate has never been higher. There is a direct correlation between how much Canadians are spending on homeownership and a corresponding decline in their savings rate. This lack of saving is problematic on its own, but if housing prices fall, the impact on homeowner equity could be catastrophic. This type of disruption can hurt Canadians of all ages, but particularly those in or near retirement. By eschewing diversification in favour of homeownership, many Canadians are putting all of their eggs in one basket.

This lack of diversification – and its consequences – has been illustrated by the COVID-19 pandemic. When lockdowns were imposed in March 2020, the Canadian federal government introduced CERB and banks offered mortgage deferrals to preserve household solvency. Millions of Canadians availed themselves of these programs to stay afloat because, among other concerns, most household equity is locked up in residential real estate and many people did not have enough savings to make ends meet without government support. So how can Canadians work towards financial independence while also planning for the unexpected? Well, one option is to hold off on costly homeownership and work with licensed professionals who can help you diversify your assets.

Conclusion: The Importance of Diversification

Homeownership provides many benefits, both financial and psychological. However, in this three part series, we have looked at some of the reasons why waiting longer to buy a home can actually help you achieve your financial goals faster. For many young Canadians, much of this is already intuitive. The rising costs of homeownership, the freedom of renting, and the independence that comes with a balanced and diversified portfolio of assets can be incredibly appealing. Now, you have a few more reasons to tell your friends and relatives why you are holding off on buying a home – and why it is actually a smart decision.

None of the foregoing is legal advice – it is always important to consult with a licensed professional when completing transactions or planning your financial future.

About Jeremiah Kopp

Jeremiah has an MBA from the Asper School of Business and a law degree from the University of Ottawa, and he is currently articling with a national law firm.

You may also like

The Prime Rate in Canada: Understanding the Fundamentals

In Canada, the current prime rate is 2.45%. Understanding the importance of Canada’s prime rate is an essential component in ensuring that you are getting the best possible interest rate on your credit products through your financial institution.

Registered Disability Savings Plans: What They Are & Why They Matter

A Registered Disability Savings Plan (RDSP) is a type of savings plan that is focused on helping persons with disabilities attain long-term financial security. In order to qualify for an RDSP, the individual must be eligible for the Disability Tax Credit (DTC).

Subscribe to Modern Money

Enter your e-mail to receive updates on new articles from Modern Money, the ultimate guide for young professionals.

Don't worry, we won't send you any spam.
Share via
Copy link
Powered by Social Snap