How do I become a billionaire? What are assets? Why is the sky blue?
Let’s take on the second question about asset type and their associated pros and cons and address the other two another time. In fact, I’m going to identify the major asset types so that you can get a comprehensive overview of the investing universe.
Regardless of how much money you have (or feel like you don’t have) it is crucial that you understand the pluses and minuses of each investment type. Generally, high-income individuals have different concerns than their lower-earning counterparts (e.g., tax implications vs. not knowing how to open the right type of investment account) so read this article with an eye towards what matters to you most right now and possibly in the future.
One of the biggest questions in investing is whether price reflects the value of the asset. This is also one of the core debates in academic finance, or at least it was leading up to the awarding of the Nobel Prize in Economic Sciences to Shiller and Fama who, fittingly, disagree about the Efficient Market Hypothesis. I I will take up this topic in detail in another article, but if you can’t wait to learn more about it read this paper by Burton Malkiel.
As a disclaimer and practical purposes, this article is not intended as investment advice, only general information purposes so do not infer anything in this article as suggesting appropriateness of investability for your particular situation.
Let’s start with the key word in investing: “security”.
A security is any investment product that can be exchanged for value and involves risk and must be transferable between two parties. The owner must be subject to loss of some or all of their investment.
I’m not sure about you, but that description sounds like the furthest thing away from “security” to me. Who came up with that name anyway? The U.S. Supreme Court came up with it, not a marketing guru.
Although “securities” are associated with stocks, bonds, and other investment instruments, the U.S. Supreme Court gave a broader interpretation in the case of Howey vs. SEC (1946). The court found that the plaintiff’s sale of land and farm services constituted an “investment contract” despite the fact there was no stock or bond, per se.
This case established the Howey Test, which dictates that an investment is a security (and therefore can be regulated as such) if:
- There is an investment of money.
- The investment is made into a “common enterprise.”
- The investors expect to make a profit from their investment.
- Any expected profits or return
If you’ve been following the news about digital assets (discussed later on in this article), you’ll appreciate how important this is for regulating assets and considering whether you should own them yourself.
The key part of the term is that you as an investor need to be acutely aware that you might lose money by buying it. A hard lesson to learn is that just because something is offered on an exchange, it doesn’t mean that it’s a good idea to buy. From a legal perspective, the only requirement that an investment prospectus must adhere to is that it be accurate, not good (Mitts, 2019). This puts the onus of understanding investment quality on the investor and their representatives, so as the adage goes, “know what you own”.
With no further adieu, let’s take a look at common investment types’ pros and cons.
Stocks represent ownership in a publicly traded company. When you buy a stock, you become a shareholder in that company and are entitled to a portion of its profits. When people say, “I bought company yada-yada” they generally mean that they bought equity shares.
There are two main share classes of equity, common and preferred shares. Common shares provide voting rights, capital gains, dividends (maybe), and are the most “junior” asset type (meaning holders of common shares are the last to get paid in case of liquidation). Preferred shares provide a dividend, are considered more “senior” from a capital structure perspective, and do not change in price for the most part. This investment shares characteristics with bonds because they are issued with a face value and pay a dividend. The market value is simply the prevailing price and it can appreciate in market value based on firm performance but to a lesser extent than common shares.
- Potentially high returns over the long-term: Stocks have historically provided higher returns than other asset classes over the long-term. According to the S&P 500 index, the average annual return of stocks over the past 100 years has been around 10%.
- Potential for dividend income: Some stocks pay dividends, which can provide a steady stream of income to investors.
- Opportunities for diversification across different sectors and geographies: Investors can diversify their portfolios by investing in stocks from different sectors, such as technology or healthcare, or from different countries.
- High volatility and risk of loss in the short-term: Stocks can be highly volatile, meaning they can fluctuate widely in price in the short-term. This can result in significant losses for investors, and a triggering of behavioral reactions such as loss-chasing that can cause even more long-term losses.
- Dependent on the performance of the overall stock market: The performance of individual stocks is often tied to the performance of the overall stock market, which can be affected by various macroeconomic factors (this is known as “non-diversifiable risk” and measured by “beta”). This means that even if you picked a promising investment it can be affected by unrelated events.
- Individual company risks, such as bankruptcy or fraud: Investing in individual stocks can be risky, as individual companies can face risks such as bankruptcy, bad business models (e.g., Silicon Valley Bank) or fraudulent activities (e.g., Enron). This is largely whey the academic approach to investing for most individual investors is to own diversified exchange traded funds (ETFs).
An annuity is a contract between an individual person and an insurance company. When you purchase an annuity, you pay the insurance company in installments or a lump sum and in exchange, the insurance company makes periodic payments to you for a finite period. Many people buy annuities to get a steady stream of income in retirement because of its relatively low risk profile and lack of need to regularly manage.
Here are the three main types of annuities:
Fixed: Pays a guaranteed interest rate for a preset period, such as ten or twenty years (after the “accumulation” period is over).
Variable: Does not have a guaranteed interest rate as it fluctuates based on the performance of the underlying investments (e.g., stocks and bonds). This is considered a higher risk investment relative to the fixed type.
Index: Interest and payments are wholly determined by the performance of a stock market index, such as the S&P. These are risky because the underlying assets fluctuate significantly. Here’s a helpful article by the Financial Industry Regulatory Authority (FINRA).
Bonds are a form of debt where you lend money to a company or government in exchange for regular interest payments (this is why bonds are considered “fixed income”) and the return of your principal when the bond matures.
There are various types of bonds, such as corporate, municipal, government, and bond ETFs. I like this article on investor.gov for more information on bond risks, yet it seems like there should be a section dedicated to junk bonds and perhaps include something about actual, major fraud that took place in the 80’s (ahem, Milken) when blond mullets and convertible Ferraris were in fashion. At the time of this update (June 7, 2023 at 12:05pm EST) junk bonds are experiencing higher default risk due to credit constraints (relevant article) .
The devil is in the details when it comes to bonds, because there are non-obvious differences between these bond types that can make a big difference, especially for high-income earners. For example (this is not tax advice, just an example) municipal bonds (called “munis”) are exempt from federal taxes, and if the investor resides in the same state issuing the bond, the muni will often be exempt from state and local taxes. If you’re a high net-worth earner, the tax exemption boosts the bond’s return relative to alternative fixed income choices. As I said, it’s not obvious, so it’s worth doing your due diligence about fixed income possibilities.
Bond prices vary, yet not as much as equity prices and defaults don’t follow the same pattern of equity price crashes either. An interesting paper by Giesecke et al. (2010) looks at 150 years of bond defaults and finds that the corporate bond market has experienced clustered default events much worse than those experienced during the Great Depression. This is counter-intuitive, as you’d expect macroeconomic crashes to directly affect companies’ abilities to pay the coupon on their debt obligations. It turns out default events are only weakly correlated with business downturns and that that credit spreads do not adjust in response to realized default rates.
Bond defaults seem to be partially predictable, here’s an interesting paper on Moody’s default forecasting.
Generically, here are the pros and cons:
- Generally less volatile than equities: Bonds are generally considered to be less volatile than stocks, meaning they can provide more stable returns over the long-term.
- Fixed interest payments provide regular income: Bonds provide regular interest payments, which can be a source of steady income for investors.
- Can provide diversification within a portfolio: Bonds can be used to diversify a portfolio and reduce overall portfolio risk.
- Lower potential returns than equities: Bonds typically provide lower returns than stocks over the long-term. In fact, the “equity premium puzzle” asks the question of why long-term investors choose bonds at all given how much lower their returns are.
- Inflation can erode the value of interest payments and principal: Inflation can reduce the purchasing power of interest payments and the principal amount invested in bonds. The U.S. government offers protection from inflation losses with TIPS.
- Default risk for lower-rated bonds: Bonds with lower credit ratings can have a higher risk of default, which can result in significant losses for investors.
Alternative assets are titled this because they serve as “alternatives” to the traditional stocks and bond investment options.
Here is a relevant article by the Wall Street Journal about private and alternative investments. Illiquid alternative investments make sense if and only if you are a large institution that has extensive expertise, time, risk tolerance, new money, and size. If you do not, these investments are probably not good investments for you, especially for retirement.
However, there are firms that specialize in alternative investments and provide an accessible method for non-professionals to benefit from these large, illiquid capital placements. As a Canadian example, Westcourt Capital in Toronto specializes in alternative investments for high net worth investors with the appropriate cash needs and risk preferences.
Real estate investments can take many forms, including rental properties, commercial buildings, and real estate investment trusts (REITs). Real estate investments typically generate income through rent or lease payments and appreciation in property value.
- Potential for steady rental income: Real estate investments such as rental properties can provide a steady stream of rental income for investors.
- Appreciation in property value over time: Real estate investments can appreciate in value over time, providing potential capital gains for investors.
- Opportunities for diversification across different types of real estate: Real estate investments can be diversified across different types of properties, such as residential, commercial, or industrial real estate.
- High transaction costs and illiquidity: Real estate transactions can be expensive and time-consuming, and it can be difficult to quickly sell a property if needed.
- Property management can be time-consuming and expensive: Managing rental properties can be time-consuming and expensive, especially if repairs or maintenance are needed.
- Dependent on the local real estate market and economic conditions: Real estate investments are highly dependent on the local real estate market and broader economic conditions, which can be unpredictable.
Commodities are raw materials or primary agricultural products that are traded in bulk, such as gold, oil, or wheat. They can be traded through futures contracts, options, or exchange-traded funds (ETFs).
- Can provide diversification benefits to a portfolio: Commodities can provide diversification benefits to a portfolio, as they often have low correlation with other asset classes such as stocks and bonds.
- Some commodities, such as gold or oil, can be used as a hedge against inflation or currency fluctuations.
- Commodities can provide high returns in certain market conditions, such as during periods of high inflation or when demand for a particular commodity is high.
- Commodities can be highly volatile, with prices fluctuating widely based on supply and demand factors, geopolitical events, or weather conditions.
- Not all commodities are easily predicted and there is massive price risk. Lack of experience in commodities trading led some speculators to order physical delivery of oil and be unable to receive it, sending the price into negative territory such as occurred in May 2020 (see interesting academic paper on the topic here).
Cash and cash equivalents
Cash and cash equivalents are investments that can be easily converted to cash, such as money market funds, treasury bills, or savings accounts. When people joke that they keep their cash under the mattress, this is usually what they’re referring to.
Is it a good idea to stash cash instead of investing it? Let’s take a look at some pros and cons:
- Liquidity: Cash and cash equivalents are highly liquid investments that can be easily converted into cash when needed, providing a level of financial flexibility and security.
- Low risk: Cash and cash equivalents are generally considered to be low-risk investments because they are not subject to market fluctuations or volatility.
- Easy to manage: Cash and cash equivalents are easy to manage and do not require much time or effort to maintain.
- Stable returns: Although the returns on cash and cash equivalents are low, they are generally stable and predictable.
- Low returns: The returns on cash and cash equivalents are typically lower than those on other investments such as stocks, bonds, or real estate. This means that holding cash and cash equivalents may result in a lower overall return on investment.
- Inflation risk: Over time, the purchasing power of cash and cash equivalents may be eroded by inflation, which can result in a loss of value.
- Opportunity cost: Holding cash and cash equivalents may mean missing out on potential gains from other investments that offer higher returns.
- Currency risk: If holding cash in a foreign currency, there is a risk that changes in exchange rates could result in a loss of value.
Angel Investing & Venture Capital
Angel investing is a form of investment where high-net-worth individuals or groups invest in early-stage companies in exchange for an ownership stake. Historically, investing in early stage companies was inaccessible at small amounts or to non-wealthy investors, but there are platforms dedicated to providing early-stage companies with investors from various walks of life.
Here are some pros and cons of angel investing:
- Potential for high returns: Angel investing offers the potential for high returns on investment if the company is successful. Early-stage companies can grow rapidly and increase in value, resulting in significant profits for angel investors.
- Active involvement: Angel investors can actively contribute to the success of the company by offering their expertise, experience, and networks. This involvement can provide a sense of fulfillment and satisfaction for the investor.
- Diversification: Angel investors can diversify their investment portfolios by investing in a range of companies across different industries.
- Early access to innovative ideas: Angel investors have the opportunity to invest in innovative ideas and technologies before they become mainstream, providing a potential competitive advantage.
- High risk: Angel investing is considered to be high risk as the majority of early-stage companies fail. The likelihood of losing all or part of the investment is high.
- Illiquidity: Angel investments are illiquid and require a long-term commitment as it can take several years for the company to grow and become profitable or be acquired or go public.
- Limited control: Angel investors typically have limited control over the company’s decision-making process and may not have a say in how the company is managed.
- Lack of transparency: Early-stage companies may not have a track record or financial history, making it difficult for investors to evaluate the company’s potential for success.
In summary, angel investing offers the potential for high returns and active involvement in the growth of early-stage companies. However, it is a high-risk, illiquid investment with limited control and transparency. It’s important to consider your individual financial goals and risk tolerance when deciding whether to invest in angel investing. It is also important to conduct thorough due diligence and seek professional advice before making any investment decisions.
Private lending is a type of investment where an individual or entity lends money to another individual or business, usually for a specific purpose, such as starting a new business, buying real estate, or consolidating debt.
Like any investment, private lending has its pros and cons.
- High returns: Private lending can offer higher returns than traditional investments like stocks and bonds, especially in a low-interest-rate environment. Depending on the terms of the loan, private lenders can earn interest rates ranging from 6% to 15% or higher.
- Diversification: Private lending can be a way to diversify an investment portfolio. It can be a good option for those who are looking to balance their portfolio with different types of investments, including alternative investments.
- Control: Private lenders have more control over their investments than they would have in traditional investments. They can choose the borrowers they want to lend to, and set the terms of the loan, including the interest rate, payment schedule, and collateral.
- Asset-backed: Private lending is typically secured by collateral, such as real estate or other assets, which can provide some protection to the lender in the event of default.
- Risk: Private lending can be riskier than traditional investments, as the borrower may default on the loan or the collateral may not be sufficient to cover the loan amount.
- Illiquidity: Private lending investments can be illiquid, meaning it can be difficult to sell the investment if the lender needs to access their funds quickly.
- Lack of transparency: Private lending investments may not be as transparent as traditional investments. The lender may not have access to the same level of information about the borrower or the investment as they would in a publicly traded company.
- Legal and regulatory risks: Private lending investments may be subject to legal and regulatory risks, such as compliance with state and federal securities laws, which can add complexity and cost to the investment.
Overall, private lending can be a viable investment option for those who are willing to take on more risk and want to diversify their portfolio with alternative investments. However, investors should carefully evaluate the potential risks and rewards before investing in private lending opportunities.
Cryptocurrencies are a digital form of currency that use encryption techniques to secure and verify transactions and control the creation of new units. I served as the first Chief Economist in the digital asset space, so reach out directly if you’d like to chat about it.
Here are some pros and cons of investing in cryptocurrencies:
- Potential for high returns: Cryptocurrencies offer the potential for high returns on investment if the value of the cryptocurrency increases (capital gains). Some cryptocurrencies have experienced significant growth in value over a short period.
- Decentralization: Cryptocurrencies are decentralized and not controlled by any central authority or government, offering an alternative to traditional financial systems.
- Anonymity: Transactions made using cryptocurrencies can be anonymous, providing a level of privacy and security for users.
- Accessibility: Cryptocurrencies are accessible to anyone with an internet connection and a cryptocurrency wallet, making it easy to invest and trade.
- High volatility: Cryptocurrencies are highly volatile, and their value can fluctuate rapidly and unpredictably. This makes them a high-risk investment and probably best categorized as “speculation”.
- Lack of regulation: Cryptocurrencies are not clearly regulated by governments or financial institutions, leading to concerns about fraud, money laundering, and other illegal activities. There are cross-country differences in the way that digital assets are treated and tax laws are non-uniform.
- Security risks: Cryptocurrencies are vulnerable to hacking, theft, and fraud. If a user’s cryptocurrency wallet is hacked, they can lose all their investment. Exchanges of digital assets have been hacked by outsiders, insiders, and tremendous amounts of money held by customers lost and/or stolen.
- Limited acceptance: Cryptocurrencies are not widely accepted as a form of payment, limiting their usefulness and value.
In summary, buying cryptocurrencies can offer the potential for high returns, but it is a high-risk speculation with high volatility, security risks, and limited acceptance. It’s important to consider your individual financial goals and risk tolerance when deciding whether to invest in cryptocurrencies. It is also important to conduct thorough research, seek professional advice, and be vigilant about security measures when purchasing cryptocurrencies.
Non-Fungible Tokens (“NFTs”)
NFTs (Non-Fungible Tokens) are digital assets that are unique and cannot be replicated or exchanged for something else. They are often used to represent digital art, collectibles, and other unique digital assets. Here are some pros and cons of investing in NFTs:
- High potential for value appreciation: NFTs can appreciate in value over time as their rarity and uniqueness increase, resulting in high potential returns for investors.
- Easy to trade: NFTs can be traded easily on various platforms, making them highly liquid and accessible to investors.
- Diversification: NFTs can provide diversification for an investor’s portfolio, especially for those interested in the art or collectibles market.
- Transparency: NFTs can be traced back to their origin, providing transparency and authenticity for the buyer and seller.
- High volatility: NFTs are highly volatile, and their value can fluctuate rapidly and unpredictably. This makes them a high-risk investment.
- Limited liquidity: Although NFTs are easy to trade, their liquidity is limited compared to other investments, which can result in difficulty selling them at a desirable price.
- Lack of regulation: NFTs are not regulated by governments or financial institutions, leading to concerns about fraud and scams.
- Unproven market: The NFT market is still relatively new, and its long-term sustainability and viability are uncertain.
In summary, investing in NFTs can offer the potential for high returns and diversification, but it is a high-risk investment with high volatility and limited liquidity. It’s important to consider your individual financial goals and risk tolerance when deciding whether to invest in NFTs. It is also important to conduct thorough research, seek professional advice, and be vigilant about security measures when purchasing NFTs.
A Closing Note on Active Management of Assets
Behavioral economists, finance, and industry researchers have looked into how people fare and the news isn’t promising–most people destroy value through frequently buying and selling assets. Actively managing any of these assets by buying and selling is called “tactical asset allocation” and can make or break your portfolio regardless of the assets you hold.
The one general piece of advice I offer all people is that they know clearly what type of investment tney are making and to have the requisite knowledge, discipline, and temperament for that respective approach.
For example, investors buy and hold assets they believe are priced below their intrinsic value for extended periods of time, sometimes years and decades. Contrast this with day traders who buy and sell assets without much regard for the underlying asset and are out of the position before the end of the day. Swing traders hold positions for longer than day traders, but generally are not primarily focused on cash flows or meaningful fundamentals. Each of these approaches can be applied to the assets discussed in this article and it is worth investing time in learning the behavioral biases, such as those discussed on this website, that affect investors. If you’d like to know which investment biases affect your portfolio performance and addressing them will unlock profits, check out the Investor Optimization approach or reach out directly.