I’m not sure if homebuyers truly realize how much concentrated risk they are taking when they buy property. I’m particularly concerned about first time buyers putting less than 20% down because they can’t afford a larger downpayment. Given they can’t put at least 20% down, it’s likely they also don’t have any meaningful investments in stocks, bonds, or private ventures. In other words, they are all-in and then some with real estate.

Just in case it’s not obvious, mortgage debt is also considered investment risk exposure. You’re basically leveraging up to make a concentrated bet on a single asset that hopefully goes up. If it goes down and you need to sell, you’re screwed. During the last downturn in 2008-2009, the average American’s net worth got destroyed because over 80% of the average American’s net worth was in real estate.

Some people have asked me why I’m not in a bigger rush to reinvest 100% of my house sale proceeds (~$1.8M) in this bull market. If I did, I’d still have $815,000 less in risk exposure because I paid off the mortgage.

The first reason why I’m not in a rush to reinvest the proceeds is because it’s a lot of money and I don’t want to lose it. I’ve redeployed about 60% and am slowly re-investing the balance each month. The other reason I’m in no rush is because I still have roughly $1,000,000 in mortgage debt, meaning that with a current cash balance of ~$900,000, I’ve got maximum exposure + $100,000 in leverage to risk assets.

The Definition Of Maximum Exposure

Maximum Exposure is not just investing everything you have in risk assets like stocks and real estate. Having Maximum Exposure is investing everything you have in risk assets AND borrowing as much as possible to also invest in risk assets.

With real estate, banks will generally lend your household up to 5X your annual household gross income. With stocks, brokerage accounts may let you borrow up to 50% the value of your stock holdings in the form of margin. For the record, I’m not a fan of going on margin buying stocks or taking a HELOC out to buy risk assets.

The time to have Maximum Exposure to risk assets is when there is blood in the streets. That time period was most recently between 2009 – 2010. The problem is that nobody can properly time their Maximum Exposure to perfection. It can only be done in hindsight.

Given perfect timing is impossible, one must raise and lower their exposure during a cycle. The long term trend is luckily up and to the right. But the desire or ability to work is finite, and so is life itself. There’s no point dying with boatloads of money, especially if it’s going to be taxed at 40%.

I did a reasonably good job getting Maximum Exposure from 2003 – 2007 with investments in stocks and two San Francisco properties and one Lake Tahoe property. Total mortgage indebtedness was roughly $2,200,000 as a 27 – 30 year old. Then I went backwards for several years until the market started stabilizing in 2010, and ultimately recovering.

I wanted to de-risk by $1.1M in 2012 because I had just left my job, but nobody wanted to buy my property at the asking price. By the time 2014 rolled around, a 4.1% CD came due and I had the fire power to buy another property to gain Maximum Exposure again.

It’s strange how quickly my mindset changed from de-risking to increasing risk in two years, but I decided to take on $1,000,000 more in debt to buy a fixer in Golden Gate Heights because my online revenue was growing, my net worth had rebounded, and I strongly believed buying a panoramic ocean view home on both levels for $720/sqft was a no brainer.

The Definition Of Full Exposure

After selling my rental house this summer, I’ve now only got Full Exposure. This is exactly what I want after a ~60% rise in San Francisco property prices since 2012, an ~82% rise in the S&P 500 since 2012, and a ~130% rise in the NASDAQ during the same time period. Further, given my site’s size and the fact that I’m still a one man band who now has fatherly responsibilities, I’m expecting online revenue growth to slow.

Full Exposure is defined as investing all your cash flow and having all your assets tied up in risk assets plus a comfortable buffer. The comfortable buffer is up to each individual. For me, I like to have at least $100,000 in cash for emergencies or investment opportunities.

Full exposure also requires one not be leveraged to a risk asset, or have cash equal to the amount of mortgage or margin exposure. Given I have about the same amount of mortgage debt and cash, I’ll further refine my definition and describe my exposure as Synthetic Full Exposure.

Because I’m not sure how long the bull market will last, I’m concurrently paying down mortgage debt and investing in stocks, bonds, and cheaper real estate investments around the country each month. The goal is that by the time a bear market arrives, I’ll have less debt, additional gains in risk assets to buffer for a downturn, and plenty of cash to take advantage if things get really ugly.

The Definition Of Reduced Exposure

I define Reduced Exposure as investing less than 70% of your regular after tax, after all expenses income and having more than 30% of your net worth in risk-free assets like cash, CDs, treasuries, and municipal bonds. Reduced Exposure is great leading up to a bear market and for at least the first year of a bear market. Eventually, you’ll want to switch from reduced exposure to Full Exposure once there are indications that the bear market has bottomed.

Again, it’s impossible to perfectly time the market. Therefore, it’s important to do your best to manage your risk exposure at various points of the cycle. It’s not bad to sell a little too soon or buy a little too early. You don’t want to be selling when everyone is selling, nor do you want to buy when everyone is buying. The herd mentality destroys pricing rationality.

I’m not in Reduced Exposure mode yet because corporate earnings are still very strong, interest rates remain low, and the government is trying to be accommodative to businesses with tax reform. Although it feels like 2007 again, it also feels like the party could continue for a couple more years.

Little-To-No Exposure = Misery

You can have little-to-no exposure to risk assets, but that type of exposure will likely leave you bitter at life because you’ll have to work forever or experience endless envy towards those who bought a home. Read any real estate section in any major city newspaper and you’ll feel the angst of the writer talking about how unaffordable prices are. The same goes for the stock market section where journalists regularly make fun of the meteoric rise in certain stocks and cryptocurrencies. You can bet your bottom dollar all the authors have been left behind.

Don’t get left behind.

In 20-40 years, your children will ask you why you didn’t take advantage of today’s low prices. We all wish our parent’s bought as much ocean front property and unhealthy McDonald’s stock when they were young. My grandfather could have bought beach front land in Waikiki during the 40s for nothing, but he didn’t want to be next to a butcher. Darn it.

One thing I will note is that after you achieve your stretch net worth goal, you can’t help but want to run up the score even more in a bull market. One reason why is because you know the bad times will eventually come again and you want as big of a buffer as possible. Another reason is simply because you can afford to take risk with money you didn’t think you’d ever obtain.

To achieve financial freedom, more than half the battle is to simply have enough risk exposure for as long as possible. The exact type of exposure you have is secondary. You can read endless articles and books about why such and such an asset allocation is best.

Here’s my take on the proper asset allocation of stocks and bonds by age and my recommended net worth allocation by age and work experience.

My hope is that everyone who reaches their stretch net worth goal uses the money to buy themselves time. Time is always running out, which is why I encourage everyone to retire by a certain age and not a certain financial figure.

Readers, what type of risk exposure do you currently have? How do you plan to adjust your exposure in the coming years? 

The post The Main Types Of Risk Exposure To Be Aware Of When Investing appeared first on Financial Samurai.

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