Mr. Worst-Case Scenario

May 11, 2007

Robert Shiller called the tech-stock crash just as the Nasdaq peaked. But he is also the expert on the real estate market. And where does he think it's headed now? Uh-oh.

Robert Shiller is worried about your home's value, and that's not good. A finance and economics professor at Yale, Shiller proved he could see a crash coming with his book Irrational Exuberance, which forecast the end of the 1990s stock bubble and hit bookstores in March 2000 almost to the day the Nasdaq started to collapse. Today, Shiller believes homes are roughly as overvalued as stocks were then and, once again, he's worth listening to. A research company he co-founded, Case Shiller Weiss, created the definitive index of housing prices. A newer venture, MacroMarkets, designs ways to hedge against risks like falling home values. In short, no one else knows the history—and perhaps the future—of U.S. real estate prices better. Shiller spoke recently with MONEY's Jason Zweig.

Q. What caused the stock bubble, and why did it end as it did?

A. Some sociologists talk about collective consciousness. We humans evolved to be very closely linked, and our minds focus on the same ideas. Those [ideas] get reinforced because we hear them all the time. Back in the late 1990s, you kept hearing that you had to stake your claim on the Internet or you'd miss out on the future. No one cared about the present. Then something happened around March 2000. There was an acceleration of public talk about doubts. You could no longer declare at a cocktail party that Internet stocks were going up. Such statements had become embarrassing—and just like that, word of mouth changed. Embarrassment is a powerful emotion.

Q. Is that about to happen in real estate?

A. It doesn't seem like we're there quite yet. But this is the biggest boom in housing prices since, well, ever. Nothing seems to explain it, and nobody forecast it. It seems to me...wait a minute. Please don't quote me as forecasting the markets.

Q. Okay. What you're about to say is not a forecast.

A. Well, human thinking is built around stories, and the story that has sustained the housing boom is that homes are like stocks. Buy one anywhere and it'll go up. It's the easiest way to get rich.

Q. So how rich can you get on real estate?

A. From 1890 through 1990, the return on residential real estate was just about zero after inflation.

Q. Excuse me? That's all? Hasn't it been higher lately?

A. Since 1987 it's been 6% [or about 3% a year after inflation].

Q. So real estate doesn't go up roughly 10% a year?

A. It can't be true that homes rise 10% a year. If they did, in the long run no one would be able to afford a house.

Q. Let me grab a calculator. If real estate really rose 10% a year, a $25,000 home in 1957 should be worth roughly $3 million now.

A. And that flies in the face of common sense. In fact, I'm inclined to think there's a good chance that the return on real estate will be negative, substantially negative, over the next 10 years because all booms reverse in the end.

Q. All right. We won't call that a forecast either. So how should people think about their home as an asset?

A. Avoid concentration of risks. You need a house, but I would avoid a second one—or at least avoid an outsize house. Overinvesting in real estate now would be a recipe for disaster.

Q. You also write about the risk to human capital. What's that?

A. What you're trying to do is to invest in skills that somebody else will want to pay you for. Let's say you want to work at Bethlehem Steel. That would have been a good idea in the 1950s, not so good by the 1970s. The world went the wrong way on you.

Q. How can you manage that risk?

A. I used to coach children's soccer, and I would tell my players, "Stand away from the pack, and sooner or later the ball will come to you." In your career choices too: Get away from the pack. Also, you associate your home country with safety. But the rest of the world is pretty peaceful too, on average, and the average is all that matters. I think relatively few [Americans] are getting away from the pack, investing more outside the U.S. than in.

Q. How are you investing now?

A. I'm probably a little over 60% in stocks, almost all of it outside the U.S. I have a lot of cash. And I've been reducing my exposure to real estate. It may be at the end of a cycle.