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A simple view of assets

2020-05-22, Michael Thompson

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A simple view of assets

In this article we provide a simple, high-level discussion of various assets. From just this view, one can see the benefits and risks of the various assets, and why they hold or increase value. Most of us know these things, but it may be helpful to revisit and contemplate the basics periodically.

Stocks

Shares of stock represent ownership of a corporation. Corporations use labor / material to produce goods / services. Successful corporations earn profit that can be distributed to shareholders via dividend payments and / or buybacks. A percentage of profits may be used to obtain additional labor / material or improve operations (research), facilitating an exponential increase in profit over time. This explains why shareholders can receive compound interest on their investment. However, if a company fails to sell its products / services for profit over time, it eventually cannot reward shareholders. At some point, the company may extinguish its resources and credit, forcing it into chapter 7 bankruptcy. In this case shareholders lose their investment, except for any assets not allocated to other stakeholders (common stock shareholders are last in line to receive company assets).

A downside of stocks is that most people overestimate their ability to pick them. Even if you spend a great deal of time researching a company, and you are an expert in their technology / business, you may still fail at stock picking. There are a few reasons for this. First and foremost, there are typically many such experts already in the market, and hence share price has already accounted for their opinions. Then there are the things people fail to accurately predict: “random” external events like the COVID19 crises or a cyber-attack can subtract a decade’s worth of earnings in a matter of days. This is why even the top experts don’t buy shares in just one company; they diversify their investment across many companies.

Some companies will fail, some will stagnate, and others will experience explosive growth. Over our lifetime, it’s likely that increases in efficiency will cause the total market cap of stocks to continue to grow exponentially. For this reason, buying an equity index fund like VT is a good approach for most of us (see this article about exceptions).

Gold and precious metals

Unlike shares in a company, gold does not produce anything. An ounce of gold today will still be an ounce of gold 10 years from now and nothing else. This has benefits and drawbacks. Benefits include the inability to fail or vanish (like a company issuing stock), and the unlikelihood of a sudden increase in the amount (supply) of gold relative to fiat or other assets. The main drawback is that it doesn’t create value. Unlike companies or farm land, gold bars don’t produce new things of value (two gold bars don’t make gold babies!).

Precious metals have industrial uses (see this), but these typically account for a small fraction of their trading value. The dominant factor in the trading value of gold is simply the fact that many people believe they can trade it for another asset (e.g. fiat currency) in the future.

Some people claim the inability to price a precious metal relative to its properties is a drawback. An investor can estimate a fair value for a share of stock by reviewing the number of shares, earnings, debt and so on. He can decide that he wants to buy GM because it’s very likely it will profit 10 USD next year for each 100 USD he spends on shares (of course, there is no guarantee, but typically such estimates can be made with reasonable precision). There are no such estimates for gold. If the price of gold doubles tomorrow, should we buy or is it a rip-off?

Other Commodities

Commodities like oil or cattle derive value from enabling the production of other goods. They are typically not reusable, and many do not create new value (e.g. two drops of oil don’t create a third drop of oil). Hence, many do not have this fundamental reason for exponential growth, like stocks. However, they have the potential to increase when demand outpaces supply. In our world of fixed / limited resources, you may expect this to be the case most of the time. However, human ingenuity (and greed) often works around this. For example, consider how the electrification of cars and other gas-powered machines is curbing the demand for oil.

Fiat Currency

Fiat currency is the most useful asset for trade. Your employer trades your time for it, then you trade it for food, shelter, transportation, entertainment, and other assets. For this reason, holding a certain amount of fiat is necessary. Beyond that, fiat doesn’t have good properties. It doesn’t grow value like a successful company or farmland, and its supply is not constrained like Bitcoin or gold. In fact, central banks have caused hyperinflation several times by increasing the supply of fiat too fast. A famous example is the Weimar Republic in the early 1920s.

Cryptocurrency

Cryptocurrencies like Bitcoin are somewhere between gold and fiat currency. Some, including Bitcoin, have the advantage of a fixed supply limit. This limit is more constrained than gold - a new gold mine or technology could radiacally increase it's supply. However, it must be pointed out that the total supply of all cryptocurrencies is not limited – it can change on a whim.

Another advantage Bitcoin has over precious metals is the ease of storage and transfer. Anyone who has bought and sold physical gold can tell you it’s not convenient and often results in a significant loss having to buy at a premium from a dealer, potentially pay for secure storage, and sell at a discount. (Even “paper gold” includes fees for storage, administration, etc.)

On the downside, Bitcoin doesn’t create new value and is reliant on people’s belief for its current value. Worse, you can’t make jewelry or anything out of Bitcoin – there’s no “backup source of value” to support the price if speculators lose interest.

The average person likely feels less comfortable owning Bitcoin compared to a similar asset like gold. Bitcoin’s short history is partially to blame – it’s only been in existence for a decade. Gold has held speculative value for thousands of years. Also, security mechanisms protecting Bitcoin are not well understood by most people. Your grandfather may feel comfortable sitting in front of his gold safe with his gun, but not putting money into Bitcoins housed in an internet-connected exchange (or even storing a “mysterious” Bitcoin key or wallet offline).

Bonds

A bond is a contract in which the investor lends money to the issuer, with the expectation that the money be paid back over time with interest. The issuer will typically use that money in some productive pursuit like building a road or hiring a software engineer. The issuer will typically earn money in this pursuit (e.g. by taxes in the case of governments) and use that money to pay the investor. This is why, like stocks and farmland, it’s reasonable for a bond investor to receive compound interest over time. Of course, some issuers will fail in their pursuits and be unable to pay the investor. In this case the investor may not receive the expected repayments and could lose significant money. In some cases, the issuer will be dissolved and their assets liquidated to at least partially reimburse bondholders and others.

Summary by analogy

Here’s a summary with somewhat useful analogies.

  • Owning a stock is like owning a machine that can potentially create money at an increasing rate over time. Some of these machines will not produce much or even break, leading to partial or complete loss of investment.
  • An equity index fund provides partial ownership of many such machines, e.g. 500 for VOO. Even if some of these machines fail, the investor can be successful if the average machine continues to create money at an increasing rate.
  • Bonds share many properties with stocks, but the performance of the “machine” is more predictable – it’s less likely to underperform but also less likely to overperform. They can still fail, but you’re more likely to recoup some of your investment by reselling parts.
  • Commodities are analogous to the components used to make the machines. If they become scarce and are still needed to make the machines they can appreciate, but often humans will find another way to make the machines, avoiding expensive/appreciating commodities.
  • Precious metals are the decorations on the wall in the machine room. These decorations have remained on the wall for thousands of years while hundreds of thousands of machines have been created, failed and replaced. They can’t fail, but they don’t create anything either. They don’t help the machines much, but the workers like them and are willing to buy them. If the workers lose their taste for these decorations, they could completely lose their value.

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