Generally speaking, each dollar that you save can be deployed toward one of the following assets: cash, commodities/hard assets, bonds/fixed income, real estate, and stocks/business ownership. Below, I discuss the characteristics and historical performance of each asset class and I list my view of the best assets to own in ascending order:
Worst Asset Class: Cash And Cash-Equivalents
Cash is, by definition, designed to erode in value. The Federal Reserve of the United States has a stated target of 2-3% inflation (depending on the year), meaning that every dollar in your pocket will only buy $0.97 or $0.98 worth of goods this time next year as you can purchase right now. Since 1964, the purchasing power of the United States dollar has decreased in value by a factor of 7.7, making cash just about the worst asset to own over the long term. If you put $1,000 into a safety deposit box in 1964, you would only be able to purchase $129 worth of goods today.
However, some investors draw the wrong conclusions from the information stated above. They think: “If cash is not only unproductive but counter-productive, then the best approach must be to keep cash holdings to a minimum.”
No, no, no. That conclusion is not what I recommend. Cash has two purposes, one defensive and one offensive.
First, cash serves the defensive purpose of “keeping you in the game” and preventing you from ever being in the position of forced selling. The large one-time expenses as life, as well as the possibility of job loss, tends to occur at the same time general economic conditions deteriorate and force you to sell other investments at a lower price than you would like. At a minimum, your cash position should be enough to fund the entirety of a reasonable worst-case sudden expense scenario so that you would never have to sell any of your other assets due to need.
Second, cash serves the purpose of letting you play offense when times get tough. Warren Buffett has observed that, when excellent bargains present themselves, investors should reach for their buckets rather than teaspoons. If your available cash to invest is limited by what you bring in every two weeks, you will create a gap in which your ability to take advantage of excellent deals lags your ability to do so. It reminds me of the Mark Twain line about how a man that chooses not to read books throws away his advantage over the illiterate man who cannot read them.
Essentially, the theory of holding cash for attractive opportunities rests on the argument that the degree of a good deal will eclipse erosion in the value of the dollar during the waiting period. If you find an excellent asset like Brown Forman trading at a 25% lower stock price three years from now, it is worth the 10% or so decline in your purchasing power because you’re still getting a 15% gain.
The drawback of piling up cash while waiting to buy attractive cash-generating investments is that you must compensate for both inflation and those years in which you did not collect cash. As Benjamin Graham once said: “It is far from certain that the typical investor should regularly hold off buying until low market levels appear, because this may involve a long wait, very likely the loss of income, and the possible missing of investment opportunities. On the whole it may be better for the investor to do his stock buying whenever he has money to put in stocks, except when the general market level is much higher than can be justified by well-established standards of value.”
Personally, I think the conversation about how much cash to hold is always going to be more art than science because the wisdom of your decision is heavily dependent on subsequent events. Someone who loaded up on cash in 1991 didn’t get a chance to deploy it until late 2001. Meanwhile, someone who started compiling cash in 1999 or 2000 would have seemed much more shrewd. I would say the best approach would be to immediately get enough cash on hand to withstand personal crisis, and then select a low to modest sum to add to your cash position each month that will act as your capital to play offense during times of distress.
Inflation-Matching Asset Class: Commodities And Hard Assets
Corn. Oil. Wheat. Gold. There is no commodity asset that exists which has beat inflation by more than 2% per year since 1900. My view is that the purchase of hard assets like commodities should only be done with an eye towards preserving purchasing power in the spirit of storing value rather than creating wealth.
I do understand why gold is attractive. It has been a store of value for over 2,000 years, always able to be traded for something of economic value in any country anywhere. And plus, there is the cool factor. Touching gold is fun. It feels a lot better than touching recently manufactured pennies by the U.S. Treasury that reek of quantitative easing. Gold certainly feels like wealth. It is understandable why a notice investor would consider gold one of the best assets to own.
Since gold became widely traded in 1980, it has only increased in value at a rate of about 2%. If you purchased gold in 1980, you would have actually lost about a point per year in purchasing power. Maybe that will rebound a bit during the recession and give gold a track record that nearly matches inflation, but that only serves to reinforce the argument that gold is a store of value rather than a creator of wealth.
If you can’t help yourself—something about the tangibility of gold, its shiny luster, and its historical record of transferring value across civilizations appeals to you—do me a favor and first purchase a cash-generating asset to make your purchases of a commodity such as gold.
Get your hands on 1,500 shares of oil giant ExxonMobil and use the $1,125 dividend checks that you receive every 90 days to purchase an ounce of gold that you can add to your stockpile in a safety deposit box every quarter. I suspect what will happen is that you’ll eventually see how much more wealth Exxon produces that you’ll quit this project altogether, but even if you don’t, you have at least built a system that adds an element of self-sustaining repeatability to your approach that enables to perpetually acquire gold or other hard assets in a near-passive manner.
Low Wealth-Building Asset Class : Bonds And Other Fixed-Income Assets
The appeal of owning debt issued by governments or businesses is that you are a securing a contract right. If a government fails to make good on a debt payment, it enters default. If a business fails to make a debt payment, it is insolvent. The legal consequences of this are so drastic that both businesses and governments must prioritize debt payments for the health of their near-term futures. Sometimes, these debts are backed up by claims on actual assets in the event of default (secured debt) and sometimes they are backed up by nothing other than the reputation of the business (unsecured debt).
As an investment, I do not even begin to consider fixed income as an investment unless I am convinced that I will receive at least 3.5% net of tax returns. Why? Because that is the historical rate of inflation that I use as my baseline of expectations for purchasing power erosion over my lifetime. I never want to make an investment that will give me less purchasing power years from now than I possess today. That is a punishment for the virtue of delayed gratification and sounds like something out of a Bizarro World Aesopian fable.
In terms of safety, my preferences for fixed-income investments are, all else equal: (1) debt issued by the United States, Switzerland, Germany, and Great Britain; (2) debt issued by large multinationals that generate profits of billions of dollar per year; (3) debt issued by other governments; debts issued by profitable businesses; (4) and lastly, so-called junk bonds that are issued by unprofitable businesses or new businesses with an unscrutable track record.
Of course, the “all else equal” provision almost never applies in real life. You have to figure out: At what point are junk bond yields so much higher than what you’d get from Swiss debt that a diversified basket of the former will lead to better risk-adjusted results than the latter?
My short-hand guide is as follows: High-quality government debt should receive your preference when it yields over 5%, high-quality multinational debt should receive your preference when it yields over 7.5%, debt of other governments and junk bonds should receive your preference when it yields over 8%.
Also, there is a bit of curve when it comes to junk bond debt. If you buy a junk bond yielding 8%, you historically have an 83% chance of collecting your full income due (the 17% chance of default is why you must* diversify into hundreds of junk bond investments via a fund or index of some sort). But when a junk bond yields over 10%, you only have a 22% chance of collecting your full income due.
Why the drastic fall-off? Well, it is true that higher interest payments imply a lower-quality business model and balance sheet, but there also seems to be something about human nature that kicks in once debt crosses the 10% threshold that makes the business executives think: “We have got to restructure or something. This debt burden is killing us.” That “or something” means bankruptcy or some type of delinquency on your debt obligations.
With large multinationals and established governments, it is fine to purchasing debt on an individual issuance basis and build a collection of fixed income generators. When it comes to lower-quality governments and businesses, I think it is best to expect a meaningful percentage of defaults and widely diversify with the expectation that the gains from the payers will more than compensate for the defaults.
And broadly speaking, you should remember that there is usually no “growth kicker” with debt payments. Governments and companies usually agree to pay a fixed sum each year for the duration of the bond. As the years go on, their tax bases and earnings power may grow more robust, but you don’t participate in this except to the extent that your probability of collecting your full interest payments increases. Fixed income, at its best, should be viewed as an asset class that modestly enhances your existing wealth.
Moderate-Wealth Building Asset Class: Real Estate
When you rent out property to others, be it through a rental home or apartment complex that you own, or through a real estate investment trust (REIT) in which you purchase shares, you stand to collect 3-7% in annual income and receive an annual growth kick of around 3.5% that is the result of expected annual rental increases.
I do not usually cover the ownership of rental properties because the initial costs are often far more significant than initially projected. Real estate broker costs, loan/closing costs and other transaction fees, repair costs, insurance, advertising costs to market the property, property tax payments, tenant defaults, legal costs to enforce judgment against defaulting tenants, and mortgage payments during periods in which the property remains vacant vary dramatically and make it difficult to speak in broad strokes about the benefits of rental home ownership.
If you want to own real estate assets outright, my recommendation is that you delay the purchase of this kind of asset until you are wealthy enough to do something like purchase an apartment complex outright. This is because you want to have a diversified tenant source. If you have 100 tenants on your property, you can absorb the drawbacks mentioned above through your sheer size and diversification base. If you only own an individual rental property, the pitfalls noted in the previous paragraph can turn your so-called investment into something that consumes part of your monthly income rather than provides reliable cash flow.
The best approach for the middle and upper class is the purchase of real estate investment trusts (REITs) which instantly enable you to diversify into hundreds of properties with expert management teams and competitive total returns (since 1995, real estate investment trusts have generated 8.2% annual returns).
The catch with REITs is that part or all of their dividend payments may be taxed at your ordinary income tax rates which can be as high as 43.8% rather than the lower capital gains rate of 23.8%. This higher tax rate is exacerbated by the fact that a little over half of REIT returns come from their dividend payments. If you are a California doctor, REITs investments are probably not going to be on the short list of best assets to own for your taxable accounts because of the very high tax burden. To avoid this, REIT investments should generally be confined to IRA and other tax-advantaged accounts where you do not have to face the income tax rate on the dividend and can permit the investment to compound over time without being disturbed (that’s why I recently argued that W.P. Carey is an ideal REIT IRA investment for those that value high and growing tax-free cash flows).
The Wealth-Building Asset Class: Stocks And Business Ownership
There is little question that I generally view as the best asset class to own. Heck, this conclusion encouraged me to launch this website dedicated to common stock investment. The reason why stocks have been so superior—delivering 10% annual returns since 1926 according to data compiled by Ibbottson & Associates—is because of retained profits and production growth that acts as a wealth turbo-charger while the price of the products rise.
Earlier, I pointed out that commodities investors cannot rely on price growth that exceeds inflation. If you purchase 1,000 barrels of oil and hold it for 25 years, your return will be limited to whatever the price of oil is 25 years from now. But if you purchase stock of an integrated oil major like Exxon or Chevron, you also get to benefit from production growth. Every fifteen years or so, companies like Exxon and Chevron sell twice as much oil as they previously did. Plus, they share some of these profits with their owners by sending them a share of profits in the form of cash dividends which can be reinvested into additional shares so that you own even more of the business.
This pattern is not limited to commodities stocks. In 1977, Anheuser-Busch (BUD) could sell you a beer for $1.13. Over time, the average cost of a beer has risen to $4.83. If you are a shareholder of Anheuser-Busch, you not only benefit from the fact that the price of beer has increased from $1.13 to $4.83 over the past forty years but you also benefit from the fact that Anheuser-Busch went from selling 20 million barrels of beer to over 100 million barrels per year. This shift upward in production is the primary determinant of why stocks have delivered greater returns than any other asset class.
Generally speaking, the best assets to own among stocks are small-cap value indices such as The Vanguard Small-Cap Value (VBR) ETF. Since 1926, these types of stocks have delivered 12% annual returns while large-cap American stocks have delivered 10% annual returns. Over a lifetime, this seemingly small two point difference can be staggering. On a $10,000 investment held for forty years, a 10% investment return will net you $537,000 while a 12% annual return will net you $1.1 million. Over a lifetime, a small-cap index can create doubled the wealth that you can get from a large-cap index.
What is the catch with small-cap stocks? They are almost twice as volatile as large-cap stocks, and they underperform for long periods of time. Between 1926 and now, the small-cap index has fallen more than 50% on more separate occasions and has fallen by at least 35% on two other occasions. If you own $1,000,000 in a small-cap stock fund before the age of 55, you have a one in three chance of seeing it fall in value to the $500,000 range by the time you are 75 based on the experience of the 20th century. The payoff with small-cap stocks is tremendous, but you better make sure you can withstand the volatility before you pursue it.
Small-cap stocks tend to offer you 12% annual returns over the course of your lifetime. Large-cap stocks tend to offer you 10% returns. Real estate investment trusts (REITs) tend to offer you 8% returns on a pre-tax basis. Fixed income returns can vary dramatically from 3-9% annually depending on the duration and type of bond you purchase. Commodities such as gold and oil tend to offer you 3.5% long-term returns that match the rate of inflation. And cash tends to erode in value at a rate of 2-3% per year.
The assumptions laid out above assume that you everything you buy is purchased at “fair value.” Of course, sometimes investments are on sale, and sometimes they trade at a higher value than they deserve. When the U.S. stock market is high, an bond fund indexed to the debt of emerging market governments may offer competitive returns. During the 2009 financial crisis, the value of REITs became so low that they went on to offer superior returns from their lows. But as a general rule, stocks and other types of business ownership are the best assets to own assuming everything is trading at a fair price.