Perspectives on asset classes: What I wish I knew when I was younger

Every investment is made with the expectation that the purchased asset will generate an attractive return through distributions, appreciation, or both.  With this perspective, it’s useful to differentiate between assets that have the capacity to generate income, versus those that don’t. More concretely, bonds, notes, bills and deposits generate income in the form of interest payments, assuming they don’t default; stocks give owners the possibility (likelihood?) of an expected stream of income that is either distributed in the form of dividends or otherwise reinvested in the company; other assets like precious metals, commodities, art, or bitcoin, offer only the prospect of price appreciation with no opportunity to realize any associated income unless they are managed in conjunction with other ancillary activities like selling options against those positions; and finally there’s real estate.   

I have something to say about each.

Bonds, notes, bills, and deposits

(For expository purposes, I’ll refer to all these interest-bearing instruments as bonds.)  Although bonds come with a wide variety of designs, in this context, I’ll confine myself to the plain vanilla type that stipulates fixed interest payments to be made periodically over some specified maturity.  Thus, barring default on the part of the issuer, the investor knows what he or she can expect to receive over the life of the bond. The yield to maturity as of the initial purchase of the bond would approximate the return that the bond will ultimately generate – an approximation because realizing that return requires all the interest payments to be reinvested for the remaining term of the bond at that same yield to maturity. That is, if, during the life of the bond, interest payments are reinvested at an interest rate below (above) the initial yield to maturity, the effective return on that bond would be lower (higher) than the starting yield to maturity. 

Critically, these outcomes assume that the bond in question will be held to maturity. If sold before it matures, however, the return could vary greatly from the original yield to maturity, depending on the path of market interest rates after the bond is purchased.  Moving to a regime of lower interest rates will push the price of the bond higher and provide the opportunity for the investor to earn a higher rate of return than the starting yield to maturity, albeit over a shorter holding period than the original horizon to the bond’s maturity date; and vice versa if interest rates rise.

Stocks

As an investment class, stocks have consistently offered the best returns over the long run over all other aggregated asset classes. This assessment reflects the performance of broadly diversified stock portfolios, such as a portfolio that replicates the S&P500 index. This performance is readily accessible by a number of investment vehicles, my favorite being the SPDR (ticker symbol SPY).  Stock investors must appreciate, however, that this elevated expected return generally comes with higher risk in the form of greater price volatility.  The expectation that stocks will out-perform in the long run notwithstanding, depending on the liquidity requirements of the investor, the possibility exists that the expected higher returns won’t be realized if the need to sell arises during a bear market. 

To give context to the issue of expected return and volatility, the average annual rate of return on the S&P500 index has exceeded 12 percent for all the 10-year periods starting with the 10-years ending in 1939 and going through the end of 2022 (i.e., 10 years ending 1939, 10 years ending 1940, 10 years ending 1941, etc.); and though the year isn’t over, it looks like the 10 years ending 2023 will follow suit. The worst interval was the one ending in 2008.  The bear market in that year, when that index fell by 37 percent, gave back almost all the appreciation of the prior nine years.   Since then, however, the effective annual rate of appreciation for all subsequent 10-year periods has remained above 17 percent per year. Given this history, one can’t categorically aver that stocks will necessarily outperform bonds even for seemingly long periods, but it does seem to be a reasonable expectation, particularly during times when market interest rates are in the low single digits.

Importantly, we shouldn’t confuse the performance of a broadly diversified stock portfolio with that of a narrow selection of stocks.  It’s not unheard of for some stocks to double or even triple in value over a relatively short time, which makes the expected return on something like the S&P500 index look like a pittance, even as attractive as it may be relative to bond returns. The attention to these high-fliers by the media instills a fear of missing out (FOMO) that induces lots of investors to choose to hold individual stocks rather than indexed portfolios. Picking stocks in advance of a rapid pace of appreciation is no easy task, given the plethora of alternatives.  I’d go so far as to say it’s a fool’s game, particularly for those who make their individual stock purchase decisions based on attractive past price performance.  The risk of getting in after it’s too late is substantial; and, as has been attributed to Herbert Stein, anything that can’t last forever, won’t.  That aphorism certainly applies to stocks that have posted above average market returns over any kind of extended period. 

Collectables – i.e., metals, commodities, art, bitcoin, etc.

Speaking about fools’ games . . .   I’m not saying you can’t make money in these markets; but the factors underlying supply and demand, which ultimately determine prices, are highly variable.  Moreover, they’re subject in large measure to unpredictable changes in market sentiment.  There’s just too much chance for me. My disdain for these assets as investment vehicles is that they fail to generate any income, and thus the prospect of gain requires finding the bigger fool – i.e., someone willing to take on your position after you’ve decided it isn’t worth keeping.  For all those who might disagree: Good luck to you.

Real estate

For many, real estate, or more specifically, their own owner-occupied house may prove to be the best investment that they ever make. This asset class is unique, however, in that at the same time it allows for (promises?) appreciation, it also delivers housing services while requiring ongoing upkeep, maintenance, and taxes.  Often, proponents of real estate as an investment point to attractive histories of price appreciation without appropriate consideration of these recurrent costs.  Beyond that, negatives for me are that (1) few of us can afford to have a diversified housing exposure, leaving us at risk of being devastated by some natural (or unnatural) disaster; (2) this investment category may be the most illiquid market segment with the highest transaction charges; and (3) the tax advantages of home ownership (e.g., the mortgage interest deduction) don’t come for free.  At least to some extent, those benefits are reflected in the purchase price of the house.

It’s not that I deny that housing has historically served as a good investment. I simply feel that its best attribute may be that it serves as a mechanism to force savings, and that’s all to the good. Buying a house for the housing services that you favor, need, and enjoy, however, is one thing. Buying a house as an investment is something else, altogether.

Conclusion

Here’s how I come out: Investing can seem daunting to the uninitiated, but it’s not that difficult for most of us who ultimately want to figure out how to allocate our savings.  Stocks and bonds deserve to be our primary holdings. Investments in stock index products should be the overwhelming dominant allocation for savings dedicated to retirement or intended for intergenerational giving.  Bonds (or other interest-bearing securities) are most appropriate when the savings are being accrued for more imminent spending requirements, where volatility considerations would discourage buying stocks. Allocations to bonds should involve maturity selections that generally correspond to the timing of anticipated cash requirements.  As far as other asset classes aside from stocks and bonds, dabble if you like, but don’t bet the ranch.

Two important caveats:

First, my preference for stock index products applies to the objective of building wealth for retirement and/or generational transfers.  To that end, I think households that are earning income and have investment horizons of, say, more than 8 - 10 years until retirement should earmark diversified stocks, exclusively, for that purpose.  While some may label this 100 percent stock allocation to be overly aggressive, I believe that characterization to be in error given the horizon that I am stipulating. As holding horizons shrink, however, say, as a retirement date approaches, a shift away from stocks toward bonds would be eminently reasonable.

Second, most people who have gotten really rich probably weren’t following my guidance about holding diversified stock portfolios. More likely than not, they assembled a much more limited set of stocks and happened to pick one or more winners, where returns ended up far surpassing those generated by a more diversified collection of stocks. (Think about all the newly minted bitcoin billionaires we’ve all read about.  They didn’t get there with a $100 allocation to bitcoin. They put much more on the line.) That success, however, may likely have been due more to luck than skill.  Many more people swing for the fences and miss, than those who end up hitting home runs. Just because someone may have ended up getting rich with this strategy doesn’t necessarily mean they were all that smart.  There’s a reasonable chance they were just lucky. 

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