When evaluating an asset class for inclusion in client portfolios (and our own), we consider three things:
First, does the asset class represent an “investment” or a “speculation?” People often conflate the terms, but an “investment,” by definition, is expected to produce a future stream of income, while a “speculation” is a zero-sum bet between the buyer and the seller on the future price of an asset. The most relevant investments are stocks (which typically pay dividends), bonds (interest), and real estate (rent). Speculations include gold, commodities, currencies, fine art, and countless other assets that produce no income. Our portfolios include only true investments.
Second, can we invest in the asset class in a low-cost manner? Venture capital, private equity, timber, and farmland may produce income, but most investors cannot access them without disqualifying costs.
Lastly, can we appropriately diversify our investment in the asset class? Angel investing or buying a rental property may produce income and theoretically could be done without onerous costs, but neither can be adequately diversified to eliminate the unsystematic risk specific to the unique investment. In the aggregate, investors are only compensated for the systematic risk inherent in an entire asset class, so that is the only risk we should be willing to accept.
Given these criteria, the primary components of our portfolios are:
• U.S. stocks
• International stocks
• Real Estate Investment Trusts (REITs)
• U.S. bonds
• International bonds
• Inflation-protected bonds
Owned in each case via a low-cost, diversified index/passive mutual fund or ETF.
Those who experience career and/or financial success will inevitably be approached by investment opportunities that fall outside this recommended list. Each of them will fail to satisfy at least one of the three important criteria. A friend’s startup, a real estate opportunity, or a prestigious hedge fund invitation will all sound enticing. The more frequently we say no, the better off we will be.