My motivation and mission:
Google sheet that contains list of all WCD lessons and links to all content:
Lesson reviewing how to use Google sheet:
I’m hoping that after my first six lessons, you are motivated to start saving money and investing!
L1 - Time Value of Money & Compound Interest
L4 - Retirement and the 3 Phases of Capital
…but what do you invest in?
In Lesson 007, I will be discussing the major asset classes that you can invest in to grow your wealth (some are definitely better than others).
The “Major” Asset Classes
People in the 1980’s would probably tell you that there are 4 asset classes:
Fixed Income (Bonds)
Equity (Stocks)
Cash and cash equivalents
Other (“Real Assets”)
In 2021, I would argue that there are 6 asset classes that are large enough and have distinctly separate properties that justify each being its own separate asset class.
Fixed Income (Bonds) - $253 Trillion Global Market Cap
Equity (Stocks) - $89 Trillion Global Market Cap
Cash and Cash Equivalents - $96 Trillion
Real Estate and REITs - $280 Trillion Global Market Cap
Commodities - Gold - $11 Trillion Global Market Cap
Cryptocurrencies - $2 Trillion Global Market Cap
Fixed Income (Bonds) Vs Equity (Stocks)
Companies (public or private) need cash in order to grow their business. The term “raising capital” simply means the company is trying to increase it’s cash position to fund various parts of its business.
There are two primary ways for a company to raise capital:
Issue debt (sell bonds)
Issue equity (sell stock)
The purchaser gives the company cash in return for the equity or the debt.
When someone buys equity, they are buying a small ownership stake of the company. They are betting that the company is going to be valued higher in the future and the value of their equity will grow.
When someone buys debt, they are buying a fixed cash flow for a defined duration in the future. Effectively, you are trading money in the present for money in the future.
The term “fixed income” is the general term applied to bonds because the bond purchaser is effectively buying a “fixed income” stream in the future.
Bonds
When you buy a bond you are giving the bond seller an up-front principal payment in return for a fixed cash payment (called the bond coupon payment) for a defined amount of time. In addition, the bond seller will return your initial principal at the bond maturation date.
However, there is a risk the bond seller defaults. The longer the bond maturation date, the higher the risk the bond seller defaults (doesn’t pay back the debt they owe - including the coupon payments and the principal). This is why longer duration debt typically has higher yields - to compensate for higher risk of default.
Bond Example: 30-Year Bond
Principal (P) = Purchase Price = $1,000
Coupon Payment (C) = Yearly Cash Flow Payment = $100
Yield (Y) = C / P = $100 / $1,000 = 0.1 = 10%
Effectively, you are paying $1,000 in the present (time 0) to purchase 30 fixed payments of $100 over the next 30 years and then receive your $1,000 principal back in the final year (bond maturation date).
I will continue the conversation on Bonds in: L-9 - Fixed Income / Bonds.
Securities (Stocks)
Stocks probably get the most attention out of all of the asset classes and it’s for good reason. I can make a strong case that the stock market (over long periods of time) has been the best performing asset class.
Buying stocks is effectively buying a small percentage of a company. Why bother risking your capital trying to start your own business when you can buy a small percentage of a large, successful company that has a proven business model and is continuing to grow?… the answer is most people don’t.
Stocks are a way for everyone to participate in capitalism and business without taking the risks of starting their own company.
Stocks are considered “riskier” that bonds. I don’t particularly like this mentality because risk depends on time horizon. If you are thinking purely in the short term, then yes, stocks are “riskier” but if you are looking 10, 20, 30 years in the future, then I would argue bonds are “riskier” due to how low yields are in 2021.
One of the simplest ways to begin investing is to dollar cost average (DCA) into low cost index funds. The two I have used are:
IVV - S&P 500 index fund
QQQ - Nasdaq 100 index fund
Especially when you are young, a large percentage of your portfolio should be stocks and a decent percentage should be index funds.
Cash and Cash Equivalents
Cash and Cash Equivalents are the least exciting asset class. It’s cash… or other very liquid instruments that can be converted into cash very quickly. They all have very low yields (if any) and aren’t really “investments”.
Examples of Cash and Cash Equivalents:
Physical cash - yields 0%
Bank accounts - savings account - yields 0 to 1%
Bank accounts - checking account - yields 0%
Money market funds - yields 0 to 1%
Foreign exchange (Forex)
The only bullet point above I consider an “investment” is Forex. Fiat currencies do not trade as one; they gain and lose value with respect to each other all of the time (although I would strongly argue they are all losing value with respect to real assets over time). For example, you could make an “investment” in Euros if you expect the USD will lose value against the Euro.
An interesting story about Forex is how George Soros “Broke the Bank of England”.
I have never participated in Forex; in my opinion, this is for computer algorithms. If you’re interested in investing in currencies… then jump to cryptocurrencies.
Real Estate and REITs
Real estate is the largest asset class with a $280 Trillion Global Market Cap… everyone’s got to live somewhere, right?
I am incredibly interested in real estate. In my opinion, rental properties should replace bonds in the old 60/40 portfolio since bonds yield almost nothing.
In the 1980’s and 1990’s, the 60/40 portfolio was brilliant:
60% stocks - provided ROI% upside
40% bonds - provided stable cash flow at 7-15% yield
But in the past 20 years, people have been willing to pay more and more for the same income stream. (Bond purchase price goes up, yield goes down). In today’s environment, the yield of most bonds is less than inflation. As such, your purchasing power is decreasing over time.
Real estate is the solution for modern day investors. Consider the example below:
Real Estate Example
There is a rule of thumb called the 1% rule that says if the monthly rental price is equal or greater than 1% of the purchase price, then the house will have great cash flow. (e.g. $1,000 rent for a $100,000 house).
In today’s real estate market, home prices have out-paced rental prices. 1% homes are difficult to find. However, there are plenty of metros in the 0.5% to 0.9% range.
Rental Example - 0.7% House - (Monthly Rent / Purchase Price)
House Price = $100,000
*Rent = $700 per month ($8,400 per year)
Operating expenses (property management, repairs, taxes) - Roughly 20% of Rent
Vacancy - Assume 10% of rent
Cash Flow = Rent - Vacancy - Operating Expenses = 70% * $8,400 = $5,880
Yield = $5,880 / $100,000 = 5.88%
The home above has a cash-on-cash return of 5.88%. This is roughly 3x the yield a 30-year treasury bond will give you!
There are two other properties of real estate that make them a fantastic investment:
You can finance the home (get a loan from a bank - typically 20% down). This is 5:1 leverage. This can tremendously accelerate gains if the property appreciates in value.
The value of the home increases over long periods of time. When you buy a bond, you get the same principal at bond maturation as you paid for it. Houses typically go up 2-3% per year! With today’s monetary/fiscal policy, I would argue this could turn into 4-5% per year.
I will explore these two properties in great detail in L-10 - Real Estate & REITs.
I will also review REITs which stand for Real Estate Investment Trust. Effectively, these are instruments very similar to stocks that can be placed into your brokerage account or IRA that give you exposure to the real estate market.
Commodities
Commodities are raw products that are extracted out of the ground or grown that are either consumed, burned, worn, or are inputs into more complex things. The major commodities are:
Metals
Gold
Silver
Uranium
Copper
Energy
Oil
Natural Gas
Coal
Agricultural
Wheat
Corn
Coffee
Sugar
The largest market place these are traded is the Chicago Mercantile Exchanger (CME). The CME allows producers to sell futures contracts to speculators in order to hedge their position.
Producers of these commodities like to stabilize their returns by using futures contracts. Basically, a futures contract is a way for a commodity producer to lock-in prices in the future.
Commodity Example - Oil Futures
WTI Futures - 1 Month in the Future
The price of 1 oil futures contract for Oct 2021 is $68.43. This means that the buyer of this contract has the right to buy 100 bbls of oil for $68.43/bbl ($6,843 total contract value).
ExxonMobil might sell one of these futures contracts if they want to hedge their risk of the oil price dropping in the next month. If the oil price drops to $58.43 in the next month, then ExxonMobil would have made $1,000 off this contract.
The speculator might buy this contract if they expect the price of oil to increase in the next month. If the price of oil goes up to $78.43, then the speculator could either:
A. Buy 100 bbls of oil for $6,843.
B. Sell the right to buy these 100 bbls of oil for $7,843 (effectively making $1,000)
The only commodity I have ever thought about purchasing was Gold. However, with the rise of Bitcoin, I wouldn’t touch Gold as an investment (…sorry Peter Schiff).
That said, it is important to track commodity prices. Commodities are a leading indicator of inflation data and this has a big impact on the bond market which will have ripple effects on the stock market.
In Lesson 011 I will do a technical deep dive of what happened in February of 2021.
TLDR
Commodity prices skyrocketed
People became scared of inflation
People sell bonds when they are scared of inflation (yields rise)
Discounted Cash Flow (DCF) of high-growth, tech companies decreases (higher discount rate; lower valuation).
High-growth, tech stocks sold-off 20-30%
My Fidelity Portfolio over the past year. My advice, learn from my mistakes; don’t repeat them.
Cryptocurrencies
Cryptocurrencies are the newest, most exciting, most diverse, and most complex asset class that has emerged in the past decade due to the rise of Bitcoin, Ethereum, and the other crypto-assets.
I think crypto-asset is a better description than crypto-currency. Although these decentralized and digital tokens can be transferred like a currency, they act much more like an asset than a currency.
This asset class is not something I will be able to cover in just one lesson. Additionally, most of the technical details are beyond my understanding. The best I will be able to do is define them from an investor’s perspective (not a software developer).
I will provide a high level breakdown of Bitcoin, Ethereum, and define the major types of Cryptocurrencies in L-12 - Cryptocurrencies.
Personally, this is the asset class I see the most potential in growing over the next decade. I can easily make an argument for Bitcoin 10x-ing to $500k purely on a store of value.
Summary
In this lesson, we covered the major asset classes and described properties of each that make them unique, interesting, and potentially investible.
For a deep dive on each asset class, see these dedicated lessons:
L-13 - Cash, Cash Equivalents, and Forex
Reference Material & Social Media
In Lesson 030 I cover how to navigate and utilize the Google Sheet I have built for all WCD lessons. This Google Sheet contains a worksheet for each WCD lesson. Each sheet has all of the Excel calculations, tables, graphs, and charts that I have posted in the respective WCD lesson. Additionally, the Google Sheet has a master “Index” worksheet that has links to all of the content associated with each lesson.
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