Before you decide what to invest in, you have to consider what you can invest in. Warren Buffett, in an excellent article for Fortune, breaks investments into three categories:
- Currency-based investments
Money-market funds, bonds, mortgages, bank deposits. - Unproductive assets
Commodities, gold, wine, art, flash motors, and so on. - Productive assets
Businesses, farms, real estate, and so on.
Category 1 is reputedly the safest. The US and British governments will never default on a bond payment because there is no cost to them to not default, i.e. they can simply print the money to make good on their payment promises. But to settle for this would be to turn a blind eye to the diminution of purchasing power that occurs over the period of time for which you own the given investment. Buffett states that the value of the dollar has fallen 86% since 1965. That is, it takes more than $7 today to purchase what $1 would have purchased at that time. Interest rates are supposed to compensate the investor for inflation risk but, in recent years, central bankers have given up even the slightest pretence of attempting to provide adequate compensation. Today, real yields are miserly and have been only recently been promoted to “miserly” from “negative”. In other words, cash on deposit just sits there, it doesn’t earn anything or grow. On the other hand, at least you know what you are going to get. Bond income appears in your account, without fail, and this can act as an anchor at times of financial stress. Equally cash, as it is just sitting there, serves as ammunition that can be deployed to take advantage of opportunity elsewhere. Something that Buffett calls his “elephant gun” but which, certainly for ISA investors, is more like a pea-shooter.
Category 2 is most definitely the most enjoyable and interesting. Could researching a short-term government bond ever be more interesting than buying a Porsche or a Picasso? However, this category is where fortunes can be lost in grand style. The main problem with unproductive assets, however, is that they pay you zero income and are therefore very difficult, if not impossible, to value. In the end, a Rolls Royce or a bottle of old wine is worth only what somebody is prepared to offer you. And, until you take that offer, it just sits there and doesn’t pay you anything in interest. Of course, if it is a vintage car, it doesn’t just sit there – you can drive it and spend money on its fuel and upkeep to worsen the investment even further. And, if it is a bottle of wine, sooner or later – in a moment of weakness – the corkscrew will be put to work.
Category 3 is the most varied. You can buy productive assets (or stakes in productive assets) and enjoy the income from these to either reinvest in other assets, or just to spend. You can buy stakes in any type of business, whether pharmaceuticals, supermarkets, fizzy drinks, fashion houses, gas utilities or miners. The trick here is to find a productive asset with pricing power, to ensure that your income growth exceeds the rate of inflation. Once you have this, then you can see the real power of compound interest, as you reinvest that income at similar (or better) rates of return elsewhere.
Sometimes you see “alternatives” listed as an asset class; this is a term which is understood to include hedge funds, private equity funds, floating rate funds etc. I don’t understand how these products can be counted as an asset class in themselves, because all they are is expensive wrappers for other assets, i.e. whatever lies within the fund. The fact that they may not be highly correlated with the S&P surely does not qualify them as an asset class? The weather is not highly correlated with the S&P, but you do not see it put forward as an asset class.
Anyway, it seems that the range of assets in which an ordinary investor can invest comprises equities, cash, bonds and, if you are feeling negative or cantankerous, gold. The next part is to decide what percentage of your pot to put into each.