Solution #1: Plan to Buy a Larger Home in the Future

The Mean Markets and Lizard Brains advice is to own some real estate but expect to move to a more expensive property in the future. If housing prices were a bubble, the correct strategy would be to own nothing and rent. Because housing prices are high, but not in a bubble, the suggestion is to own something less than your dream house. This strategy can be profitable regardless of whether housing prices fall or rise. How can this strategy win in all environments? Heres how a similar strategy worked in the stock market.

Near the top of the technology stock bubble, I found out that my older sister Sue had invested most of her retirement account in an aggressive technology mutual fund. I suggested that this was a very bad idea and that she sell. Some weeks after she agreed to sell her overvalued tech stocks, I asked if sister Sue had made the phone call to change her investment. No, she said, I havent, I dont want to miss the rally.

To solve the problem we came up with the following strategy. Sister Sue sold one-quarter of her stocks. Now, I said, if stocks go up you will make a ton of money as you still have hundreds of thousands of dollars invested. If, however, stocks decline youll have saved a lot of money by selling.

Technology stocks did decline, and Sue asked if she should buy back the stock. I said, no, now sell another quarter. If stocks rally, you will make money. If they fall, you will have saved more money. We continued this process until she completely exited her technology stocks. In the end she exited pretty close to the NASDAQ top of 5,000 and actually made money on her tech stock investments.

How can a decision to sell be good in both up and down markets? The answer is that it is a psychological trick. Obviously, the decision to sell stocks reduces profits if stocks rise afterwards. In the case of a stock market rally, I suggested that sister Sue savor the profits on the stocks she still owned, not the profits she hadnt earned on the stocks that she had just sold.

The win-win framing of selling stocks is a form of irrationality. Nevertheless, such tricks can help us precisely because we are not completely

rational decision makers. Our financial plans are often hurt by our irrationality; it is great to use irrationality to our advantage.

Owning a relatively small house also allows for a win-win outcome with the appropriate psychological framing. As always, I follow my own advice. My wife and I live in a Cambridge condominium worth a bit more than $600,000. We hope to have more children, and when we look out five or 10 years, wed like to live in a larger place. The current cost of the house we expect to own is more than a million dollars.

I can make myself believe that we will make money in either a housing boom or bust. If prices rise, we make an additional capital gain on our current property. If prices fall, our dream house will decline in price by more than our current home. Thus, we will be able to upgrade to our dream house for less than it would cost today.

So own some property, but expect to move up in the future.

Solution #2: Have a Fixed-Rate Mortgage

My advice on adjustable-rate mortgages is extreme. In As Good As It Gets when Jack Nicholsons neighbor (played by Greg Kinnear) swings by for a visit, Nicholson launches into a tirade:

never, never again interrupt me. Okay? I mean, never. Not 30 years from now ...not if theres fire. Not even if you hear a thud from inside my home and a week later theres a smell from in there that can only come from a decaying body and you have to hold a hanky against your face because the stench is so thick you think youre going to faint even then dont come knocking... dont knock... not on this door. Not for anything. Got me. Sweetheart?

I paraphrase Nicholson to say, dont get an adjustable-rate mortgage, not even if you are sure you will move in one year, not even if the adjustable-rate mortgage payment is much smaller than the payment for a fixed-rate mortgage. Not for anything.

There are actually at least three good reasons to have an adjustable-rate mortgage. First, real estate professionals may rationally want to take a gamble in the area where they are experts. This applies to my nephew Brent. If anyone is going to be able to get out at the top, it is likely to be a professional like Brent with his finger on the pulse of the market.

Second, adjustable-rate mortgages can be perfect for someone who knows she or he will sell soon. Consider, for example, a person who will move in two years and who has an adjustable-rate mortgage that is fixed for the next three years. For this person, an adjustable mortgage is almost as safe as a fixed-rate mortgage. (Even in this situation, adjustable rates are bit more risky because plans change and the fixed-rate mortgage provides more flexibility.)

Third, people who have lots of financial reserves can use adjustable-rate mortgages. A central problem with an adjustable mortgage is that a homeowner may be forced to sell into a down market. If the homeowner has plenty of money stashed away for such a day, then there cannot be a forced sale. So people who can afford fixed-rate mortgages can afford to bet against the pros and not risk too much.

It is said that banks are willing to lend to anyone who doesnt need the money. Similarly, adjustable-rate mortgages provide lower payments but should be used primarily by those who can most afford the higher payments of a fixed-rate mortgage.

So most, but not all, people should avoid adjustable-rate mortgages. My advice on this subject is precisely the opposite of that of Federal Reserve Chairman Alan Greenspan.19 In a speech on February 23, 2004, Chairman Greenspan noted that in the decade prior to his speech, those with adjustable-rate mortgages paid far less than those with fixed-rate mortgages. He also pointed out that adjustable-rate mortgages are far more common in some other countries. He concluded, the traditional fixed-rate mortgage may be an expensive method of financing a home.

I disagree with the chairman for two reasons. First, I believe that interest rates are likely to rise. Thus, when adjustable-rate mortgages come to their adjustments, I expect payments to increase.

Second, an adjustable-rate mortgage is a bet on interest rates. If rates