I often get one question from people I meet when they find out what I do for living - what is the most profitable way of investing? My answer usually is lottery tickets. Ridiculous as it may sound, this type of investment provides the highest potential return of all. If your ticket wins, your return on investment may be as high as several million per cent. I hope you see where I am going with it.

High potential return is usually associated with high risk. While this principle is obvious in this silly example and very few people would actually think about lottery tickets as a prudent way of investing their money, it is staggering to see how many investors fail to recognize this basic principle in less extreme situations. The most educating in my opinion is the recent mass obsession with investing in real estate in BC.

While it is true that in the last five years our real estate outperformed even stocks and many investors felt like they had won a lottery, its historic average return has only been around 8%, as compared to 10.8% in the TSX. Any textbook on investing will tell you that real estate is generally considered a riskier and more volatile investment than stocks. Another look at historic performance would reveal that average cycle in this market lasts four to seven years. The last boom lasted twelve.

A reasonable conclusion should have been that a larger than normal downward adjustment was to be expected. One more basic principle is that the value of volatile asset classes tends to fluctuate around their intrinsic value. With stocks this intrinsic value is determined by earnings per share, and in real estate it is simply the median income multiple. Median income times three is considered to be a normal multiple, which means that if the median household income in Vancouver is around $60,000 per year, an average house should be worth around $180,000. Sounds crazy? I don’t think so.

Again, if we look at historic values we will see that house prices have generally followed this rule, sometimes staying slightly above their intrinsic value, sometimes below. The benchmark house price in Vancouver reached about $750,000 at the peak last May. Today it is around $640,000 (or lower, depending on when you are reading this post). It is very entertaining to hear realtors saying that this is a good time to buy, when a simple look at the fundamental investing principles tell us that this number has to go below $180,000 before recovery may become possible. I am not down on investing in real estate. 8% is not a bad long term return after all, and real estate certainly has its place as a part of your investment portfolio. But when I see thousands of people investing everything they have in a single asset class, especially as volatile and illiquid as real estate, I want to ask them to slow down and look at fundamental investing principles.

Nikolay Sisan is a Certified Financial Planner and freelance writer in Vancouver.