Good Advice Gone Bad: A Rare Case Where Diversification is a Bad Idea

Some bits of wisdom seem so universally true that you can dispense them to anybody at any time and think that you are giving out good advice. Take for example the admonition to stop at red lights. It seems like a good idea and for the most part you cannot go wrong following it. On the other hand ignoring advice like this is likely to end up badly. The same holds true for the principle that you should diversify your portfolio. It just seems like the kind of advice that is always right. Well, almost always as we shall soon see.

On May 16, 2005 CNN-Money published on their web page an article by Paul Keegan titled "Mr. & Mrs. Newburg rebuild a dream house" with the subtitle "They're fixing up their castle by the sea -- if they don't go broke first." Skipping to the end of our story, the article advised them to pay down their mortgage, keep some of their funds liquid, and when the building was complete diversify their holdings away from real estate. This seems like a perfectly sensible plan at least at first. But, why it may not be will take a bit of explaining. All of the details regarding the Newburgs comes from the CNN-Money article and my analysis is based only on what the article contains. This is mostly because I do not actually know anything about the Newburgs other than what is in the article.

The Newburg's story begins eighteen months ago with the purchase of a run down home for $1.27 million dollars. While this may seem like a lot (ok it is a lot) they hoped to fix it up and turn it into a bed and breakfast. Thus, this was not only the purchase of a home but also of a business to be. However, between the purchase date and when the business would open the Newburgs would have to live off of their savings and Mr. Newburg's annual salary of $130,000. A rule of thumb is that a couple can afford a house equal to about three times their annual income. So, as a residence this house is far beyond their means. However, as a bed and breakfast it may not be.

By now you might be pondering the fact that this story begins eighteen months ago. Does that mean the bed and breakfast is open? Maybe you should visit it? Alas, as of the date the article appeared the inn was not yet open. When the Newburgs purchased the house they planned to save money by doing a lot of the renovation work themselves. Unfortunately, even using their own labor the renovation took longer and the expenses were larger than they had apparently anticipated. According to the article they have since run out of cash and are quickly running out of the energy needed to finish the construction work themselves. What to do? Enter Bob Ryan of Resolute Financial in Newburyport, Massachusetts. According to the article Mr. Ryan looked over the numbers and came to the conclusion that the family needs to pay down their mortgage and at some point diversify away from real estate.

The news for the Newburgs is not all bad. Beyond the house they are due to sell nine condominium units that they believe will yield $300,000 and they own an office building that could potentially generate another $175,000 in cash. What is the advice from Mr. Ryan? The article states that they should use, "half the money to pay down the primary mortgage and another $45,000 to pay off the second mortgage." After that they should, "Put the remaining $105,000 in safe, short-term investments, like money-market funds and CDs that the family can tap as needed to help with cash flow. For longer-term goals, the family should invest 80 percent of any money they're able to save in stock funds, 20 percent in short-term bond funds." Off hand this seems sensible. By paying down the mortgage the Newburgs will reduce their interest costs. In the long run (when exactly is that?) if they can put some money into stocks they will have something of a cushion should real estate prices collapse.

So what is wrong with the advice the Newburgs were given? Telling somebody in their situation to "pay down their mortgage and then diversify" is like telling a drowning person to cut back on beef. The drowning person's immediate problem is not high cholesterol and the Newburg's immediate problem is neither the mortgage nor a lack of diversification. They need to get that house done as quickly as possible. While the house remains unrented it chews up capital at a rate of over $4,500 each month. Until the bed and breakfast is running they are going to need a ready supply of cash. If they pay down their mortgages they will have a very hard time getting their money back out. (They would need to go through the potentially expensive and time consuming process of mortgage refinancing.) Putting any of the money into CDs would be another bad move. Bank CDs typically include significant penalties for early withdrawl; penalties the Newburgs will likely be forced to pay as they liquid assets to finish the inn's construction. Another problem is the article's recommendation that they keep only $105,000 in cash. It is not obvious that is enough to finish the job. (They have already spent $200,000.) Worse yet, it will clearly take several additional months before the first customers can be welcomed in. That means some of that $105,000 will have to go towards their current living expenses. Instead they should put 100% of their money into a high grade low cost short term bond fund. The interest from the fund will cover most of what they could hope to save from the reduced mortgage funding. In addition should they need more than $105,000 to finish the job it will be easy for them to retrieve their money. Unlike CDs you can liquidate shares in many bond funds without penalty.

Since the Newburgs first priority should be to finish the renovations they should throw every available penny towards that end. Personally, I would strongly recommend they sell the office building they own in order to further add to their liquid assets. However, Mr. Newburg seems unwilling to move his office into the new house so selling the building may be asking too much. After the bed and breakfast is up and running then all of their remaining funds and future savings should be placed far away from real estate. (There is that office building again.) Mr. Ryan's advice on that front is more or less on the mark. The Newburgs could do a little better by targeting their investments into stocks that perform well when the Northeast hospitality market does badly. That way if business dries up temporarily their stock portfolio should cushion the blow. I am not sure I would even recommend that they pay off their mortgages. If the opportunity arises to reduce the interest rate they should clearly do that by refinancing. But, by channeling the funds into stocks that do well when their bed and breakfast is likely to do poorly they can help ensure the long term survival of their business. As an added benefit if a financial crises does arise then the stocks can be easily sold. The primary problem they will face is identifying the right stocks to buy. To do so they will no doubt require the assistance of a really good financial advisor. If they do not have one then paying down the mortgage may make more sense. In the meantime they and those giving them advice should not confuse the long term value (and typically good advice) to hold a diversified portfolio with their current need to get their business from being a net drain to a net benefit as soon as possible.

©Matthew Spiegel