That is an interesting question and one that Richard will address because it is an issue he has dealt with firsthand.

As a portfolio manager, I understand this readers position. In my practice, the vast majority of my clients own their own home, and in many cases, the home represents 50% to 70% of their net worth.

Given that, it is theoretically not in one’s best interest to hold real estate in an investment portfolio, if that asset class is already overweighted within the one’s total net worth. However, as I have learned from experience, theory does not always jive with reality.

Real estate as an asset class tends to have a low correlation with equities. Without getting into correlation statistics, I would simply draw your attention to the year 2000. Note that real estate prices began to surge about the time the North American equity markets started to tank. Go back in history, and you can see similar results.

In reality, an individual who had say, 50% of their net worth tied up in the family home, probably came through the bear market with very little impact on their net worth. Despite the fact that their equity investments fell sharply.

However, from the client’s perspective, they are witnessing a sharp decline in their equity portfolio, because among other things, there was no diversifier such as real estate to cushion the downside. Rightly or wrongly, that is the fault of the portfolio manager.

So despite one’s best efforts to manage a client’s net worth, in reality, a client gains no comfort from an explanation that their net worth had probably not changed very much, despite the sharp sell-off in their equity assets.

We learn from personal interactions, and what I have learned, is that money management is as much about managing expectations as it is about producing superior results. So logic again gives way to reality, which for me, means that real estate can play an important role as a diversifier within an investment portfolio.

The second part of our readers question takes us to another level. Should the principal residence be considered part of an investment portfolio? We touched on this in a previous column, where we suggested that for an asset to be considered an investment asset, it had to meet two criteria; 1) the asset must have a tangible value that can be exchanged for cash and, 2) the only reason for holding the asset is to generate a gain, or earn cash flow or both.

Using that two condition model, the principal residence doesn’t cut the mustard. No matter how we slice this, we live in our principal residence, and thus as an asset, it does not satisfy the second condition.

If an individual were intending to downsize at retirement, you might argue that the principal residence has a role in a long term investment plan. In this case, you would have to move out of town or to a smaller property. The difference between the cost of the new home versus the proceeds from the sale of the current home, could be used to top up your investment portfolio. But again, while the logic is appealing, the reality is quite different. Most individuals do not want to pull up stakes later in life.

So what conclusion do we draw. Well, we know that real estate is a diversifier within a portfolio, and can help smooth out fluctuations when equity markets are falling. If you use real estate investment trusts (REITs) as your real estate proxy in a portfolio, then you benefit from the rental income produced within the REIT. In fact, the real benefit to a portfolio from securitized real estate, is the cash flow, in much the same way as interest payments are the real advantage of fixed income assets.