Yet another problem is that home prices may be more closely related to exposure to a local industry than to the real estate market in general. For example, in the 1980s home prices in Texas, and in oil-producing regions in general, plummetted when oil prices collapsed. Conversely, in the late 1990s home prices in Silicon Valley skyrocketed, riding the technology boom (this trend could reverse as the technology sector continues to gyrate). Homes in other areas of the same states experienced a completely different pricing environment.

The diversity of your portfolio decreases if the value of your home is based on a local industry, and if you happen to work in that industry. This lack of diversification would be further compounded if your investment portfolio is loaded with assets with exposure to the same industry to which your home is exposed. This is often true of executives that own stock in their company and/or have stock options. It is also true of employees that invest in their employer's stock through retirement plans.

A good example of the problem I have set forth above is illustrated with a real-world scenario that involves an investor who lives in Seattle, which used to be considered a one-company (Boeing) town. Accordingly, the following example might have been a very typical one:

A senior executive at Boeing owns an expensive home in Seattle. She has the vast percentage of her financial assets invested in Boeing stock. She contributes to Boeing's retirement plan, purchasing more Boeing stock. She also has stock options. She thought she had some diversification of assets because her home was considered real estate exposure (not Seattle, nor Boeing, nor airline, nor even oil price, exposure). There were several periods when Boeing was impacted by a recession in the airline industry. The company's stock, reflecting those troubles, fell sharply. Strike one for our investor. Boeing reacted by laying off employees. Being one of those laid off, strike two for our investor. With so many unemployed, Seattle home prices collapsed. Strike three for our unlucky investor. The problem was that all of the risks (employment, equity, home) that our investor incurred were highly correlated.

The bottom line is that owning a home, and considering it exposure to real estate might be similar to being a senior executive with lots of stock and options in Microsoft and thinking you have exposure to large growth stocks. The correlation of any one stock to the overall asset class of equities, or large growth stocks, might turn out to be very low. Stocks might be up overall, but your stock might be down. Similarly, real estate might be up, but the price of your home might be down. Therefore, as a general rule, investors should not consider their home as exposure to real estate. About the only real protection a home provides is against inflation in construction costs. And, since in many parts of the country land is by far a more important component of home prices than is the cost of construction, it may not be much protection at all.

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