The investing mantra has always been diversify, diversify, diversify! In essence, it means that if one part of your portfolio gets hit by forces beyond your control, your fortune will be protected by investments in unaffected sectors.

For example, a common strategy is to hold Australian industrial and financial shares as well as shares in Australian property companies. This is based on the theory that the property holdings will provide some protection if the shares get hit.

However, there is a closer correlation between the two asset classes than most people think. More than 35% of the S&P/ASX 200 is made up of banks and financial stocks, and about 60% of the banks’ assets are in residential mortgages, according to the International Monetary Fund.

Double trouble

This means that any serious fall in property values will affect a large and influential portion of the share market. If the banking system is put under stress, the economy will start shrinking and so will the stock market.

As a result, anyone holding domestic shares and property will be crunched twice.

Even though this may seem like an extreme scenario, there are plenty of doomsayers predicting that Australia is about to run out of economic luck.

The combination of high household debt levels, low wage inflation, and high property price to income ratios continues to scare many people. “I’ve been studying the market here for a good number of years and I have never seen this perfect storm of issues coming together,” Digital Finance Analytics’ Martin North said on the ABC’s Four Corners, referring to a combination of record high house prices and larger mortgages.

Housing price to income ratios*

Strength in numbers

There are mitigating factors, however. As the following chart shows, there has been a big jump in the construction of new dwellings to levels that are well above historic averages. The issue is whether this activity is speculative or largely being fuelled by demand.

The likelihood of a property crash really depends on a collapse in demand. However, buyers remain keen as property prices are still heading for the stars and the national auction clearance rate remains above 70%. While that continues, there is little likelihood of a major collapse.

Dwellings under construction

An analysis of the pros and cons of each investment class is also useful. One of the big advantages of real estate investment strategies is that they contain companies that buy real assets that rarely lose their entire value.

That’s not the case with other classes of equities, where management mistakes can quickly cut cricket scores off their market prices and turn businesses to dust.

The obvious solution is to consider international property – which as an asset class has been providing returns above inflation. It can provide diversification even for people who also hold domestic property assets.

The information provided here is general in nature and does not constitute personal advice.