A Strategy for Investing
In my previous blog, I reviewed the 5 major asset classes: equities, bonds, cash & equivalents, alternative investments, and you. As discussed previously, the most essential asset class is you and a significant focus of your time and expense should be on increasing your income-generation potential and your own personal market value. In this blog, I’d like to focus on what to do after you have invested in yourself and generated excess income. Basically, you have a choice to invest in the other 4 asset classes so let’s review how they behave and develop a strategy for designing a proper investment portfolio.
Investment Mission Statement
First, let’s develop a mission statement or strategy for investing. Most investors want to become wealthy, and they don’t want to risk losing their wealth they’ve accumulated. Wealth means purchasing power and a significant risk to losing wealth is caused by undue speculation. Hence, a good mission statement would be to grow purchasing power over time as rapidly and safely as possible without undue speculation. This seems like a good starting point.
So how do we get there? Often, investment advisors and consultants will convince you to diversify among the different asset classes. Furthermore, financial promoters and specialists will try to convince you to put some of your money into subclasses of asset classes and subclasses of subclasses and so forth. The dizzying array of investment choices can become staggering, and the promotional nature of these products can make investors feel like they are going on thrill rides at an amusement park. Unfortunately, many such products will leave the investor with nothing to show except for the memories of the thrill.
Categorize Your Investments Opportunities like Warren Buffett
Given so many asset classes and subclasses, how should we choose our investments? Well, as I learned from Warren Buffett, the Oracle of Omaha, you should not focus so much on asset classes but instead place each investment opportunity into one of three categories. They include (i) currency denominated instruments (money-market funds, bonds, mortgages, bank deposits, and other instruments); (ii) Speculative, non-productive hard assets, such as commodities and collectibles; and (iii) productive assets, including public and private businesses, farms and real estate.
Focus on Productive Assets for Wealth Accumulation but Maintain a Cash Reserve
All of the investment opportunities within each of the major asset classes can be identified in one of these three categories. However, if you want to maximize your wealth over time, you need to invest primarily in productive assets but use currency-denominated instruments to maintain a cash reserve for safety and liquidity. These two fundamental principles are essential for wealth accumulation and to increase your purchasing power over time. Now let’s analyze the investments in these three major categories and identify the major asset classes they represent.
(i) Currency-Denominated Instruments
If you invest in the first category, currency-denominated instruments (bonds, cash & equivalents), you will come to realize that their purchasing power declines over time due to inflation. In many countries, government actions and systemic forces combine to erode the purchasing power of their home currency quickly.
In the United States, where inflation is well controlled, the purchasing power of the dollar has eroded by over 86% in the last 50 years. So in 2018, you would need $7.28 to purchase a basket of goods that you could have bought for $1 in 1968. Hence, to just keep up with inflation and maintain the purchasing power on your investment, you would have required a return of at least 4.1%, after-tax or 4.6% pre-tax, assuming a 25% tax rate.
Currently, U.S. Treasury yields range from 1.89% for the 1-month t-bill to 2.96% for the 30-year bond. The yield on AAA corporate bonds is 3.47%, 4.35% for BBB bonds and 6.32% for high yield (junk bonds) corporates. Premier bank savings and money market accounts are currently offering yields of around 1.8%. Clearly, these rates will not make you wealthy and in most cases, don’t even cover the long-term effects of inflation. There is a time to invest in these instruments for wealth, and that is when interest rates are high and falling. The last time this occurred was in the early 1980s.
Given current economic conditions, you should maintain a reserve of short-term, safe currency-based instruments to preserve liquidity and cover your expenses, so you don’t have to draw down on your productive asset investments. These would include FDIC-insured bank deposits and short-term U.S. Treasuries. The amount of cash reserve you need to maintain ultimately depends on your needs. However, a useful rule of thumb is for investors who are working to have 6 months’ to a year’s worth of expenses in cash reserves and for retirees or those about to retire to have 4-5 years worth of cash reserves to cover planned withdrawals. Be sure to increase your cash reserve to cover big-ticket items, such as a new home or car, college education or an anticipated medical expense.
(ii) Speculative, Non-Productive Assets
The second major category of investments is speculative, non-productive assets, which include commodities, collectibles and other hard assets that fall under the alternative investments class. They are speculative because owners invest in them on the premise that there will be an increasing pool of investors willing to pay more in the future, which is just greater fool theory in action. Often investments in these hard assets are driven by the fear of inflation and currency devaluation and gold tends to be the investment poster child for such conditions. As the prices of these types of assets rise, fear turns into greed and a speculative bubble forms. Inevitably, the bubble bursts and the process begins anew. In most cases, the cycle lasts decades, but the exact timing is unpredictable.
In general, investing in non-productive assets generates suboptimal wealth accumulation and can lead to losses if the entry point is poorly timed. Over the long-term, productive assets are the preferred investment for wealth accumulation. Consider the following example. If you had purchased $100 worth of gold 50 years ago, it would be worth over $3,114 today, and you’d be 31 times wealthier. This is better than if you had purchased $100 worth of Treasury bonds, which would be worth $2,220 over the same time period. However, had you invested in the S&P 500 and reinvested the dividends, it would be worth $11,692 today, and you would be about 117 times wealthier.
(iii) Productive Assets
This brings us to the last category of investment opportunities, productive assets. These include public and private businesses, as well as farms and real estate. As an asset class, this encompasses equities and some of the alternative assets. Clearly, the numerical illustrations reveal that you are better off owning productive assets, from which the S&P 500 is a representative example.
In the short-term, investment opportunities appear like popularity contests, often facilitated by promoters, where investors vote in aggregate for their favorite opportunity. However, over time, the compounding effect of increasing profits generated by productive assets will drive investment returns higher and wealth accumulation faster, relative to currency-denominated instruments and speculative, non-productive assets. In the long-term, greater value is created, and knowledgeable investors will gravitate towards the value-driven opportunities in this category.
In conclusion, your strategy is to focus on owning productive assets, whether it be public or private businesses, farmland or real estate. For passive investors, public business ownership through the stock market provides the most convenient route for owning productive assets. Others may find productive asset opportunities outside of the stock market, and that is very profitable as well. Just keep in mind that you need to maintain enough liquidity so that you can cover your expenses without having to sell your productive assets. At QMI Capital, we love to help our clients find and invest in productive assets and help them design a cash management program to maintain the safety and liquidity so that their productive assets can grow. If this strategy appeals to you, contact us. Until next time.