Today I would like to describe a framework through which investments can be viewed. In this framework, there are four types of investments. Sometimes things get complicated and investments fit into more than one category, but most of the time once you have the framework, it's usually pretty easy to figure out where a new investment fits in. Let's take a look at these four types of investments.
# 1 Productive Assets
The first type of investment we should discuss is what Warren Buffett likes to call a “productive asset.” This generally refers to a business, a piece of income-generating real estate, or a piece of productive land such as a farm or timberland. The asset actually makes something. It has an income. It has profits, or at least can have profits. When you buy this investment, you are buying the future stream of earnings of the asset, discounted for the fact that a great deal of the earnings won't show up for a long period of time.
Note that it does not matter whether you own the entire asset or not. When you own part of a business, it is often referred to as shares of stock, but it can also be a partnership interest or other form of ownership. Either way, when you buy it, you're buying some or all of the future earnings.
Nor does it matter so much if the asset is publicly traded or not. While liquidity is a nice feature, so is being paid for illiquidity. The idea behind owning productive assets is that you don't mind so much if the market for it is not open for a few days or even years. You didn't buy it in order to trade it tomorrow. You bought it because you wanted that stream of earnings.
It also does not matter whether the asset pays you all of the earnings in the form of cash or reinvests some portion of those earnings. Some investors get fixated on whether an investment pays out regular dividends or not. While this can be a sign of responsible company governance, in the publicly traded stock markets, dividend investing is simply a form of a value tilt, and not necessarily the best one. In addition, if you don't actually want to spend that income this year, receiving it is counter-productive tax-wise. It is the earnings stream you want, not necessarily the dividend stream. Dividend stock investors and some real estate investors get focused too much on the income, and not the total return, i.e. the earnings stream they should care about.
I like this type of investment. About 75% of my portfolio (and something like 90% of my net worth) is invested in productive assets. Since the earnings stream can be highly variable, the short-term/shallow risk (volatility) of this investment is substantial, but its ability to withstand some of the long-term/deep risks such as inflation, deflation, devastation, and confiscation is valuable.
# 2 Interest Paying Instruments
This type of investment is the classic example of your money making money. It includes checking accounts, savings accounts, money market funds, certificates of deposit (CDs), some types of annuities, mortgages, hard money loans, peer to peer loans, and all kinds of bonds including government and corporate bonds. There may be some fluctuation in the value of the investment (as John Bogle said, you can have a stable principal or a stable earnings stream but not both), but this fluctuation is generally dramatically less than is seen in productive assets. The value fluctuates in response to two risks — interest rate risk and default risk. The higher the interest rate that a similar instrument bought today pays, the less valuable your old investment becomes. Likewise, the less likely you are to get your principal back, the less valuable your investment becomes to a potential buyer.
Interest-paying instruments, especially high-quality, short-term ones, have very low shallow risk/volatility. They are generally quite sensitive to at least two of the long term risks–the most common one (inflation) and confiscation.
The benefits of interest-paying instruments include:
- regular income
- portfolio volatility-dampening
- deflation protection
- potentially higher returns than even productive assets
The benefits of these investments argue for inclusion in a portfolio, especially for short-term goals. As such, 25% of my portfolio is invested in these instruments.
Note that there are both good and bad investments in this category. A checking account paying 0.01%, for instance, is a pretty terrible place to leave your money for any significant length of time when a money market fund is paying 2.5%.
Note also that in recent decades some types of interest-paying instruments have been designed to have less inflation risk, especially the risk of unexpected inflation. The classic example is Treasury Inflation-Protected Securities (TIPS), but others include I Bonds, “raise your rate” CDs, and index-linked gilts.
Be sure not to confuse an investment for the collateral. For example, when you invest in a mortgage or a hard money loan, you are buying an interest-paying instrument. If the payer defaults, you may end up with a productive asset (or perhaps a speculative instrument) but until that time the investment itself is an interest-paying instrument. Preferred stocks and convertible bonds are similar in that they have characteristics of more than one category. Another area where investors get confused is with negative bonds, or debt. They fail to distinguish between the debt and the asset the debt was used to purchase. “I don't want to pay off my mortgage because my house might go down in value” is a dumb thing to say because you owe the money no matter what happens to the value of the house (unless you're planning on walking away from it.) The bank doesn't really own any of the house. You own the whole house AND the whole mortgage.
# 3 Speculative Instruments
I don't even like to refer to this category as an investment, but since many in the world (mistakenly?) do, I will as well for this particular blog post.
Speculative instruments are a very broad category, but investments in this category can be readily recognized by their chief characteristic–they are purchased with the hope that down the road somebody else will pay you more for the investment than you paid. There is no earnings stream for holding this investment. Nor does it pay you any sort of interest for the use of your money. In fact, there are often costs associated with the investments–maintenance, upkeep, storage, and insurance in addition to the usual transaction costs.
Some of these speculative investments have been around for years and will likely continue to be around. These include precious metals such as gold and silver. It also includes non-productive land. Widely used currencies, fine art, collectibles, commodities, and derivatives (options, puts, etc) generally all belong on this list.
Others are so farcical that we laugh when we look back at bubbles associated with their use, such as tulip bulbs and beanie babies. Still others (cryptocurrencies being perhaps the best example) are so new that we don't yet know whether they are more akin to gold or beanie babies.
Note that these items may have other uses besides speculation. Perhaps you like to hunt on your undeveloped land. The grandkids like to play with your beanie babies. You can use your cryptocurrencies to hide money from the government. An airline may wish to hedge against a rise in the price of oil. You may enjoy looking at your art. Sometimes the difference between a speculative instrument and a consumption item is simply the use you have for it. Some types of options (such as covered calls) even have an “income stream” associated with them. But when it comes to discussing these instruments as investments, they are primarily speculative.
Note also that this doesn't mean you can't make money buying and selling these instruments, nor that they cannot be included in a reasonable portfolio. Many people have become incredibly rich by speculating wisely (luckily?), but many have also lost hard-earned money that used to be theirs due to a Fear of Missing Out (FOMO) and lack of due diligence.
Speculative investments, when mixed into a portfolio of productive assets and interest-paying instruments, may help protect against both shallow and deep risks (the best use of cryptocurrency may be to protect against confiscation and devastation for instance). However, most serious investors would be wise to limit the percentage of their portfolio invested in these instruments. In my case, I have 0% invested here. I feel like the small amount of speculation inherent in investing in productive assets and income-producing instruments is all I really want and don't believe the side benefits of some of the above listed speculative instruments outweigh their substantial downsides as investments.
# 4 Consumption Items
Like most wise investors, I don't consider consumption items to be investments at all. The general public, however, makes this mistake all the time. It is so prevalent that marketing executives take advantage of it every time they encourage you to “invest in a new car.” Well, since basic transportation costs less than $5,000, any amount you spend above and beyond that on your transportation is by definition a luxury. Don't get me wrong, I buy lots of luxuries too. But I don't call them investments.
Ever “invested” in a new wardrobe, a new tool, a home upgrade, or a new kitchen appliance? Maybe a new set of skis or a boat? Unless you're renting out that boat, it's not an investment.
Sometimes a purchase has multiple components and fits into more than one category. A house is perhaps the classic example. The house you live in actually does have an earnings stream–the saved rent you would be paying to a landlord if you weren't living there. It can also be an instrument of speculation. Who hasn't talked to their neighbor about what Jane down the street sold her house for? However, a house is primarily a consumption item and it is best if you remember that when buying one!
The more complicated the financial instrument, the more difficult it can be to place it into a single category. Some people view whole life insurance, for instance, as an interest-paying instrument because it pays dividends and/or because the insurance company invests most of their money in bonds. Technically, however, those dividends represent a return of capital (i.e. you paid too much for the insurance so the company is giving you some of your money back, that's why the dividends are tax-free) and the company has a contract with you that it must fulfill no matter how those bonds perform. In reality, life insurance, even permanent life insurance, is a consumption item. Sure, you can borrow against it (tax-free!) just like you can borrow against your car, house, or boat (tax-free!), but in reality, you're just buying term insurance and financing a permanent death benefit over decades.
Since consumption items aren't investments at all, make sure you're not using money that should be going toward investments in order to buy them. As such, 0% of my portfolio is invested in consumption items.
As you design, build and maintain your portfolio, make sure you understand the four types of investments. Evaluate new investments by first placing them into the category or categories in which they belong. Ignorance of this framework has unfortunately led far too many investors to a loss of spending power, a less than comfortable retirement, and even financial ruin.
What do you think? Do you agree with this framework? What percentage of your portfolio do you put into each category? Comment below!