WhatBubble.com

Yes, even financial columnists have to spend a day in early May with their mothers.

My mother picked me up from the airport and proceeded to drop a bomb on me – my father is retiring. He is closing his office to become a full-time gardener, online chess player and WWII scholar. This discussion inevitably wound and wended to investments and sound financial planning.

My family has historically been poor financial managers. They typically hold too much cash and often resort to stock picking rather than leaving that up to the professionals. We were discussing the last time my mother had taken an active role in the family’s finances and that was back in 1999. She had been swept up in the mania (who wasn’t besides Warren Buffet) and bought shares of Amazon, Yahoo, Go.com and a few others. The ones that are still in business are still sitting in her portfolio – at a mere fraction of her purchase price. I asked why she hadn’t sold. Her response is interesting for two reasons. She said that she didn’t want to sell because she had lost so much and wanted the stocks to go back up before she sold. She also explained that she had bought quality companies and not silly dot coms.

Her first comment, regarding her desire to avoid turning a paper loss in to a realized loss, is fascinating and one worth of reams of academic and financial discourse – but I will leave all that for another article and when I do, remind me to give all of you my elevator analogy.

The notion of buying quality assets versus ‘fad’ assets is an interesting distinction. This difference is especially relevant right now whilst we are in the midst of a housing bubble [only in certain markets – without this disclaimer, Seneca Spade starts foaming at the mouth] because I keep hearing that the main contrast between the dot com boom and subsequent bust and the housing boom and future bust is that there is real value in homes that isn’t present in stock certificates. Investors make a distinction between assets that have fundamental strength from ones that don’t. This is of course true. But it is not the whole truth.

There are many components to any investment, but the two largest are the asset and The Price. So often, people do not take in to account the price they are paying for something. In the equity markets, one hears comments like, “Intel is a horse of a company and will be around forever.” In real estate I hear things like, “coastal properties in Del Mar are irreplaceable.” You even hear it in consumer purchases “car X is extremely well built” or “company Y makes the best sounds systems.” All of these comments may in fact be true – but that shouldn’t complete the investment decision making process. There is still the question of the price you are paying for those assets and of course the price for competitive or similar assets. Let me give you two thought questions – Is the Nissan Pathfinder a good SUV? I assume that generally the answer is yes. Nissan makes good cars and trucks (one can check consumer reports or Kelly Blue Book) and further, their Pathfinder has been successful for many years. So in terms of the arguments above, we should buy it. Now, would we buy it if the price tag were $350,000? Probably not. Price is important.

This is a good time for a brief discourse on market efficiency and the glories of competition. In terms of equities, many argue that whatever price a company is trading for is probably the correct price. Their reasoning for this being true is as follows; the equity markets are extremely efficient. You have many informed buyers and sellers trading very liquid securities with prices quoted after every trade. This combination allows for investors to adjust their portfolios almost at anytime with little cost to doing so. So when news comes out, rational investors buy or sell shares affected by that news immediately. Or in other words, stock prices reflect all the current, publicly available information about a company and further, they also include everyone’s predictions for the future of that company.

Similarly, with consumer goods, competition forces prices to fall somewhat inline with values. The reason that Panasonic can’t charge $123,566.99 for a television is that we can substitute other similar TVs for the Panasonic and thus Panasonic is forced to price their television somewhat close to its competitors.

Now you can see where I am going with this – real estate, or specifically, residential real estate doesn’t really have the two previous qualities. Real Estate is a much less efficient market than the equity markets and the ability to substitute is severely diminished.

It just isn’t that efficient. There are relatively few trades, [how many homes in your neighborhood sell in a month? Microsoft shares trade about 70 million times per day]. The prices aren’t always disclosed. When they are disclosed, they are often wrong, often include special deal terms that are hard to value (seller threw in some furniture, buyer accepted a questionable termite report, seller cleaned the carpets…) and are often weeks or months old. In addition to information being somewhat spotty, trading has many frictional costs. When one sells a stock one pays $19 when one sells a house, one pays 6% (median priced homes in San Diego are around $500g so that is $30g).

It is also hard to substitute. Every home and piece of property is unique. No two lots are the same. One is closer to the intersection, one gets better light, one has better views, one has more mosquitoes. Compare that with two JVC stereos or two shares of Philip Morris. Real Estate doesn’t lend itself well to substitution.

What this means is that real estate prices and specifically residential real estate prices do not approximate the value of the underlying asset nearly as well as in the equities markets or even the super markets. So what does this mean to you? It means that in real estate the question of pricing is all the more critical. Always ask yourself, is this asset a good asset, but also, ask yourself if it is priced appropriately.

I explained all of this to my mother. She said she understood. And then she said that maybe she should sell her old dot com stocks and buy the apartment building for sale on Montana (street near the old homestead). I asked why. She said “Montana seems like a great neighborhood.”