In his recent address to the nation, President George W. Bush cited a decline in home prices as a factor in the financial crisis. But as he pointed out, the problem isn't so much that prices are down almost 20% from their peak in mid-2006, it's that many Americans were betting everything on the housing boom to continue.
For most Americans, the largest chunk of their net worth is tied up in home equity, and some got burned by an overly optimistic outlook on where housing prices were heading. Now, it's time to think more realistically about the role of home equity in an overall investment strategy.
It was easy to get caught up in the housing bubble. On average, home prices in the 10 major U.S. cities tracked by the Case Shiller Home Prices Index more than doubled from 2000 through the peak in July 2006, exceeding the S&P 500's 88% return from its low in 2002 to its highpoint in October of 2007.
Most analysts say you can typically expect a 2% to 4% annual increase in the price of your home. In the 1990s, home prices rose a cumulative 21.5%.Of course, seesawing prices have made it much more difficult for some homeowners to count on home equity in their investment plan. But as the market cools, home equity is likely to again fill the role of a low-risk investment.
Consider asset allocation. For example, having lots of relatively safe home equity can free you up to own more performance-oriented stocks and stock funds. At the same time, if your home equity stake is small, you should consider boosting your allocation to low-risk investments such as bonds or money markets.