Huge risks for huge returns – A good idea?

The previous post explained how thousands of isolated self directed IRA/401k investors could all be making the same mistakes. I see that many self directed accountholders are pursuing high returns by simply taking high risks. I believe intelligent investing is about having an extraordinarily profitable risk/reward ratio – getting high returns with disproportionately low risk.

Let’s imagine that Bob sees that older, run down areas of his city are being redeveloped. Bob also sees that gas prices are going higher and higher, and he thinks that suburban sprawl will be reversed and bring people back into the central areas that are being redeveloped. If Bob’s speculation is correct, the demand for such areas will be increasing – hopefully rapidly.

So, Bob wants to buy a home in the centrally located area that is currently being redeveloped. Let’s say he has $300,000 in his IRA and these properties cost $250,000. So he identifies and purchases a home in the target area using his IRA. He may hit a home run with this investment, but what are the risks?

  • An environmental problem with the property
  • Severe damage to the property not covered by insurance
  • Insurance premiums rapidly increase (think Florida & east coast in recent years)
  • Increasing vacancy rates due to worsening job market (think Detroit)
  • Downward pressure on prices and values from tightening up of mortgage lending

I’m sure you can think of many more. These are not reasons to put your tail between your legs and run away from investing in real estate or other alternative assets, but you have to know your risks in order to manage and minimize them.

I think the only way to deal with these types of risks is to not have too much of your investment money put into any single asset. How much is too much? I won’t go there, but it doesn’t take a rocket scientist to say that when the majority of your investment money is in a single asset, it’s probably too much.

So how does Bob diversify among several properties when the property costs $250k and he has $300k to invest? He’s got to increase his buying power.

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