Asset classes
This post is part of the Financial Freedom Guide series
So what types of assets can we invest in?
Stocks
Simply put, stocks are ownership shares in (publicly traded) companies. Companies engage in economic activities with a variety of objectives, at least one of which is usually to generate profits for shareholders (you).
These profits are then either paid out directly as cash dividends (taxable when received), returned indirectly in the form of share buybacks (taxable as capital gains when you sell), or reinvested in the business itself. These intrinsic cash flows - independent of what someone else may be willing to pay for your shares at any given time - mean stocks are a fantastic investment that will likely make up the majority of your portfolio.
There are approximately 8,000 investable, publicly traded companies in the world. As of early 2021, stocks traded in the United States account for about 60% of the global market capitalization (or valuation as expressed by # shares outstanding * price per share). Developed markets (e.g., Western Europe, Japan, Australia) make up another ~30%, and emerging markets (e.g., China, India, Brazil) round out the remaining ~10% in market capitalization.
In addition to publicly traded companies, there are many other companies in the world that are either state-owned (e.g., most of Saudi Aramco, the world's largest company) or private companies (e.g., German "Mittelstand" SMEs), which are not readily investable by the general public.
As we discussed before, the US stock market has generated an average ~10% nominal and 7-8% real (after inflation) total return over the ~200 years of its existence. It's important to understand this is an average. US stock market returns historically follow a positively skewed normal distribution (“bell curve”) with >70% of years seeing a total return in the -10% to +30% range. Also >70% of years have seen a positive return overall. In extreme outlier years the market has seen swings as much as -43% in 1931 and +54% two years later in 1933. Visual Capitalist has some fantastic graphics on this.
Over the long run, ownership of companies in the form of stocks is pretty much your best bet for achieving financial freedom.
The investable stock universe can be broken into many different segments:
By geography/ type of economy - e.g., US, developed markets, emerging markets
By industry/ sector - e.g., tech, consumer, real estate
By company size - e.g., large cap, mid cap, small cap
By dividend rate - e.g., high dividend yield stocks
By expected growth rate/ valuation - e.g., growth vs value
By Environmental, Social, and Corporate Governance issues - e.g., ESG stocks, tobacco companies, arms manufacturers
And I'm sure many more
We will look more into this in our next section on asset allocation. Suffice it to say, I recommend keeping it simple and either going by global market capitalization, or breaking the global market into a few choice market segments if you prefer to adjust their relative weighting vs their current market capitalization.
Bonds
Bonds are loans to governments or companies around the world. This ranges from safe, low yield loans to the US federal or other stable countries' governments to asset-backed securities packaged and sold by banks (like the US mortgage-backed securities that played a major role in the 2008 financial crisis) to high risk, high yield loans to small companies in unstable economies.
Here's an example for how a bond works: A government, bank, or other company goes to the financial markets and offers to pay investors a certain amount of "principal" at the conclusion of a specified "term", say, $10,000 in 30 years, plus a "coupon" - some rate of interest at a specified frequency over the term of the bond, say, 1% or $100 once a year. This debt obligation is then put up for auction and investors bid the amount of money they'd be willing to pay for this deal. The winning bid may be equal to the $10k principal or it may be more (decreasing the effective interest rate) or less (increasing the effective interest rate) than that.
Bonds aren't ownership in a company or government but rather the promise by the issuer to pay you a series of cash flows as agreed in the specified currency. And as long as you hold a bond to maturity (i.e., the end of its term) and the issuer doesn't go bankrupt, you can be reasonably confident you will indeed be paid those cash flows.
How confident you should be will of course vary wildly depending on who is making you the promise - the US government or a small company in severe financial distress, to pick two extremes. Credit rating agencies attempt to estimate this confidence on scales ranging from AAA to BBB (lowest "investment grade") to “junk”. Do keep in mind, however, that there are some conflicts of interest here. Often it is the issuers themselves who are paying the credit rating agency for its evaluation. And then the credit rating agency may simply have an incomplete knowledge of the issuer’s financial obligations or future market conditions impacting the issuer, all of which can result in an inaccurate estimate of credit worthiness. So take credit ratings with a grain of salt.
Aside from bankruptcy, there are some other risks inherent in bonds:
(1) Inflation. The amount of cash you will be paid over time may not be worth as much when you receive it as it is today due to inflation. The purchasing power of that $10,000 principal will only be worth about $5,000 in today's terms 30 years from now, even if inflation stays at a very moderate ~2% - the power of compounding in reverse! That bond paying you a nominal interest rate of 1%? Well, net of even low 2% inflation, it's actually paying you a negative "real" interest rate of minus ~1%. And that's before considering the decline in value of the principal itself and assuming inflation stays that low throughout the next 30 years - a bet I would not be comfortable making given the massive expansion in money supply around the globe since 2008. Are you sure you want to pay someone to take your money? Because that is what's already been happening in major parts of the bond market over the last decade.
(2) Buying a bond is also a bet on the currency it is denominated in. If you purchase a bond that pays out in a different currency than you will be spending (or reinvesting), the foreign exchange rate may move against you. Say you buy a USD bond but end up retiring in Europe, spending in EUR. If, between when you bought the bond and when it returns cash to you, the USD loses value vs the EUR, the money you receive back from the bond will be worth less.
(3) Most significantly in 2021, what happens if you don't hold that bond to maturity? Well, then you will be impacted by interest rate fluctuations. Whenever interest rates rise, other investors would prefer to be paid this higher interest rate rather than buy your bond that now pays a lower interest rate. As a result, the value of your bond, if you aim to sell it to another investor before maturity, will go down.
Interest rates have dropped precipitously in recent decades, dropping from 15.8% in 1981 to practically 0% in 2020. Each time interest rates dropped, this acted as a tailwind, pushing up bond returns. It's been a spectacular run for bond investors! But what goes up, must come down - or the reverse in this case. Interest rates are at absolute historic lows, with many developed nations' government bonds at negative real or even negative nominal interest rates. It appears likely that interest rates will increase at some point in the next 30 years.
All of this means bonds are incredibly risky right now. Unless you are investing for a goal less than 10 years out and can be reasonably certain you will hold them to maturity, I personally cannot recommend holding any bonds at all right now - contrary to many traditional financial advisors who still advocate for 60:40 stock-to-bond portfolios. I'll change my mind if we go back to 1980ties type conditions. To their credit, those financial advisors are probably banking on opportunities to rebalance but (a) during market crises bond values tend to suddenly become awfully correlated with stocks, limiting the rebalancing opportunity, and (b) this feels to me like betting on a lame horse just in case the race horse stumbles. Feel free to persuade me otherwise in the comments!
Real estate
There are two primary ways to invest in real estate:
Buy a house and rent it to yourself or others - check out my dedicated article on Housing - Rent vs Buy (coming soon - subscribe to encourage us to hurry up), OR
Buy REIT stocks
"REITs" stands for Real Estate Investment Trusts. They are publicly traded companies who either develop or operate real estate properties ranging from residential to commercial (e.g., offices, hotels, malls, you name it). Their fancy name derives from the special tax treatment they receive under US tax law, which exempts their corporate earnings from tax as long as they disburse 90% or more of their earnings every year (which is then taxable for you, the shareholder).
This means three things for you:
REITs pay extraordinarily high dividends, typically in the 5-10% range (after all they have to disburse 90%+ of their income)
At the same time, this low rate of profit reinvestment means REIT share prices are comparatively stable, meaning they don't swing in value in the same way as the rest of the market (they are relatively "uncorrelated", see Asset allocation)
Because of their high dividend yield, you'll want to hold REIT shares in tax advantaged accounts, if you can (e.g., US retirement accounts)
Side note: One relief to the last point for US taxpayers is that REIT income does qualify for the 20% pass-through business income tax deduction included in the 2017 TCJA tax cuts. (Surprise! Yes, a real estate mogul was US president.) Still, it's better to pay no tax at all on those high dividends than high ordinary rates on 80% of them if you can.
Overall, REITs are a fantastic addition to your portfolio. They have consistently outperformed individual real estate investors over the decades. This is in part due to REITs’ professional management, economies of scale, and ability to find the best deals across the country (or even globe) - and because individual investors often buy too much home and pay too much to nest in their home (yes, that kitchen remodel that may not investment sense - but it’s sooo nice!).
Note you'll likely already have a sizable allocation to REITs as part of your broad market index fund holdings. Buying more can make sense if you want to overweigh this category - for example if you choose to rent rather than buy and want some of your money invested in "home equity".
Alternative investments
Sound like a hodgepodge catch-all term to you? Congratulations! You win some examples:
Farm or timber land. Just what it says. Be careful not to turn this into a farm or timber land management job - unless you enjoy that sort of thing.
Commodities. See section below.
Private equity. Stocks in not-publicly-traded companies, including those startup shares and stock options you may have. Some of these may be great investments but you'll need to apply judgement - or pay some VC or hedge fund a lot of money to apply judgement for you - and be willing to put up with private equity's inherent illiquidity.
Hedge funds. Just a fancy way of saying: You may need to already be rich to be able to invest here and these are a bunch of fancy pants guys who get paid a fortune to pursue any number of investment or speculative strategies that may or may not work out for you in the long run. Just know those fancy pants guys tend to get paid a lot when they take insane risks with your money and it works out but face minimal consequences when they lose your shirt. I'm friends with a lot of them and my friends are great people - which doesn't make them any more or less fallible than the rest of us mortals. Caveat emptor.
Collectibles. E.g., vintage cars, rare wines, Beanie Babies, stamps, art, and so on. - Oh please... don't excuse your fancy hobbies as "investing" in order to escape spousal persecution! :) It's either a business you enjoy - e.g. selecting wines to age and paying someone to turn those bottles in your wine cellar - at the opportunity cost of your time and heartburn - or pure speculation.
Cryptocurrency. See section below.
Literally anything else you can come up with. I told you it's a catch-all term! Want some peer-to-peer lending, electric car credits (looking at you Tesla), carbon credits, total return swaps (yeah, Archegos Capital), or stakes in film productions? Yep, drop it here, and then forget about it.
What all alternative investments have in common is that they are:
Unregulated by the US Securities and Exchange Commission (SEC) or such other regulatory bodies working to help you keep your shirt and hard-earned financial freedom dollars
Illiquid, meaning they can't be easily sold or otherwise converted to cash
On the flip side they tend to have a low correlation with the other asset classes in this list, which makes them, in moderation, a potentially attractive addition to your asset allocation if they allow you to rebalance reasonably easily.
Commodities
Alright, this is going to be fun! Commodities refers to any easily tradable bulk good, e.g., crude oil and its derivatives, gold, or other mining and agricultural products. Here's the bad news: None of these goods will produce anything of value on their own. They don't have any intrinsic cash flows. Gold doesn't magically make more of itself. So the only thing you can do is sell it and hope somebody else will pay more for it than you did. In the meantime, you're going to have to pay some to store it and keep it safe. In short, it's not an investment, it's speculation. You're free to engage in it and some people are good at it (at which point it's a job, not passive investing). I don't recommend it.
So what about gold? Isn't it a great hedge against market crashes or if society collapses? Maybe. But that's insurance you buy and continuously pay for to keep safe, not something that will grow and ensure your financial freedom under any normal conditions. It's also worthwhile noting that an ounce of gold bought a nice men's suit 200 years ago and still does today. Just not any more than that. 200 years ago, a nice men's suit was most of what a gentleman could desire. Today you might also want a smartphone, TV, or microwave. Hedonistic inflation (coming soon - subscribe to encourage us to hurry up) is real folks.
Go ahead and revisit owning gold once your net worth starts generating more wealth than you know what to do with (say, at $5M). At that point you may want to think about buying gold as insurance and paying to keep it safe in vaults strategically placed around the world (e.g., Singapore, Switzerland, New Zealand).
If you really must invest in commodities, consider buying companies that pursue economic activities related to commodities rather than purchasing the commodities themselves. This includes companies involved in the exploration, extraction, refining, transporting, or marketing of, for example, crude oil, metals, or other mining and agricultural products. That way you benefit from the intrinsic cash flows of these companies while being exposed to the value of commodities in the same way these companies are. Nuff said.
Cryptocurrency
Yes, just like commodities, Bitcoin & Co needed their own category because I cannot in good conscience lump them into the alternative investments category. Cue the hate in the comments. Crypto is the epitome of "only worth what a greater fool is willing to pay for it" speculation. Crypto has well and truly zero intrinsic value. This distinguishes it even from commodities which at least have some use value - you can eat corn, burn gas, and turn gold into jewelry.
But that's the same as "fiat" money, like the US dollar, I hear you cry! And you'd be right. Bitcoin may indeed come to replace every other currency on the planet - although I doubt it given its inherent deflationary design; they're limited in number by design and you can lose those buggers in landfills - or be the precursor to a cryptocurrency that's capable of meeting our societal needs, such as flexibly adjusting the money supply to changes in the size of economies (it sucks when you run out of seashells to trade). Even if that does not happen, you could still get rich on the way to us all figuring that out - if you stop HODLing at the right time that is.
What you can't do is to expect any kind of intrinsic cash flows to be generated by cryptocurrency. I don't recommend "investing" in USD, EUR, or CNY either! Speaking of which...
Cash
Simply a highly liquid, temporary store of value and/or means of exchange. Currencies are claims checks on society. You can take those claims checks and buy food or fancy cars - or you can use them to invest in productive assets that will mint lots more of those claims checks for you. Generally speaking, returns in cash are minimal and you want to minimize how much cash you have lying around doing nothing.
Summary
Look at you! You've made it through this article and have some sense of what you can invest in today: Stocks, real estate, maybe some alternative investments. Perhaps reconsider wanting to buy bonds in 2021 or any meaningful quantities of commodities or crypto (beyond what you'd be willing to gamble in a casino).
Now unleash your questions and dissent in the comments section!
Next, what kind of stocks, real estate, and alternative investments should you buy and how much of them? Let's check out:
Go back: Investment basics
