“What should I invest in?” It is probably the most common investment-related question people ask. Familiar with investing or not, our society seems to have an unspeakable anxiety toward finding the “right” thing to invest in that will create better returns than our neighbor’s. Instead of giving you any tips on what specific company stock to buy, in this post I would like to provide a framework where you can work through this question on your own.
This framework, in investment strategy, is called “asset allocation.” If you google this term, you can find many sophisticated explanations and the full theory behind it. Here I intend to continue the thought process through the first two parts of this series. If you agree that the reason to invest is to share your resources before you need them, and the reward is generally secure in the long-term, then you may wonder, “What kind of reward do I get, and how do I maximize my reward?”
This leads us to two distinct ways of making a return on investment- identifying assets that grow in value in the long-term so you can sell for capital gain, or lending resources to receive a fixed income over a period of time. Some investments have characteristics of both.
Identifying Growth Potential
Let’s say you are an art collector who has a special eye for identifying a rising star. You bought a painting of a young artist at $100 when nobody saw her talent. When the artist becomes famous after 10 years, somebody is willing to buy the artwork from you for $1 million dollars. You just made a return of 10,000%!
Of course, very few have the access and skill to identify talent, so not many people can make money this way. However, this example shows us making an investment return is contingent on our ability to identify value in something when others have not, so you can buy at a low price and sell at a high price.
For most people, this is a difficult thing to do. That is why many choose to invest in residential real estate. It’s hard for normal investors to identify a particular investment among hundreds of thousands of options with any kind of conviction, so we turn to the things that we can see and are familiar with. Some may also invest in their own small business, because at least we have confidence in ourselves!
How do we get past the hurdle? Even if you have no instinct or training in identifying anything that will grow in the future, you should be able to count on one thing that will grow in the long-term- the world’s collective economy. (If collectively our economy does not progress, there are worse things you should prepare for than not making a return on investment.) To invest in the growth of the world’s economy as a whole, you can use passively managed index funds that track the movement of the world’s individual markets relative to their weight in the world’s economy.
(Or you can hire investment professionals to find this growth opportunity for you if you trust their skills. This can be in the form of investing in actively managed funds, or letting an investment adviser pick investments for you. I’ll discuss this in future parts of the series.)
However, growth takes time. Before something grows in value, it may also lose some value. (Imagine your rising star artist runs into drug troubles and loses a few years in practice.) Not everyone has the patience and time to wait for growth when it does not happen in the expected time frame. So what else can we invest in?
Another way to make an investment return is simply lending people your money and get paid interest in return. The original investment will be returned to you in the end, but may or may not have increased in value. The simplest example of this is your term deposit. You effectively lend the bank the sum of your deposit, and the bank agrees to pay you a small interest by the end of the term.
There are many other investments that fall into this category, such as bonds, promissory notes, dividend-paying preferred stock, rent-paying investment property, etc. The common theme is that you are promised periodic payments and your original investment back if you hold the investment to term. But the promise is only as good as the entity giving it. In other words, there is no “guarantee” that you can get all the payments and investment back. (Except in the case of treasury bonds, if you believe the US government will not default.)
But many still prefer this type of investment, because most of the time, the payments are made as promised. For those looking for consistent return, being a lender gives you a steady stream of income, and high probability of receiving back your original investment if you hold it to term. But, the reward is generally lower than investing in growth opportunity. In addition, if you don’t spend the steady stream of income, you need to constantly find other investments to put the new cash into; otherwise it’s just going to sit idle in cash and defeats the original purpose to invest.
In investment strategy, identifying growth potential is called investing in “equity”, whereas lending your resources is called investing in “fixed interest”. Asset allocation simply means deciding how much you invest in equity vs fixed interest. For example, you may have invested in mutual funds with the name “Balanced” in it. It most likely means that it’s 50% in equity and 50% in fixed interest. (In practice, some people further divide “sub-asset classes” within equities and fixed interest, but I won’t go into the details here.)
What kind of asset allocation is best for you? It depends on your goals, investment time frame, risk tolerance, and personal preference. If you are in your 20s and investing for your IRA, you probably can invest 100% in equities, since you don’t need the money now and have time to wait for it to grow. At the same time, you may be extremely risk averse, and want to see more stable returns year after year. In this case you may want to add some fixed interest into your portfolio.
Or if you are retired, ideally you don’t care about growth and will be happy with a certain amount of income coming from your portfolio. You may want to invest 100% in fixed interest. However, if you don’t have enough capital, or if the interest rate is very low at the moment, the income level may not come out as high as you need. Therefore you may need to add some growth assets in your portfolio to increase the base on which you can earn interest.
You may even prefer equity to fixed interest because of personal belief. Some people have an aversion to getting interest from lending as a matter of principal or religious teaching. That is understandable, too.
In the end, you may want to engage a professional to help determine the best asset allocation for your particular situation. But knowing asset allocation is only the first step. What are the exact investments- stocks, bonds, mutual funds, etc.- that we can use to fill these two “buckets”? That will come in the next part of the series.