Investment Vehicles

The primary goal of investing is not to lose the purchasing power of our hard-earned money. Except for the cash reserve for emergencies, you should keep your wealth in investment vehicles and inflation-proof assets.

A perfect investment vehicle offers protection against inflation and taxes, and provides steady cash-flow.

This article attempts to cover basics of major investment vehicles available to most investors:

1. Real Estate
2. Stocks and mutual funds
3. Bonds and CDs
4. Precious metals (gold and silver)
5. Collectibles and art

Real Estate

Real Estate is among the most basic and safe investment vehicles. There are two ways to invest in RE:

1. Shelter – an investor lives in his property. The property provides shelter and if bought at the right price an owner-occupied house provides the cash savings in comparison to rent price – this is an untaxed return. A home insurance provides the safety of capital. What is more, the first $250,00 ($500,000 for couples) of gains in value are tax free – the only requirement is that it must be the primary residence for at least two years before sale.
2. Rental property - provides regular cash-flow from rent. There might be a lot of problems with tenants, maintenance, repairs, etc. The property owner must be compensated with an extra return for all his time and effort spent on resolving problems with tenants and the property. That's why, only the properties bought at a quite low price and providing income higher than maintenance expenses may produce such return. Most investors require at least 10% return on their investment (down-payment). More on this in article Investing in Real Estate

Historically Real Estate provided a good place to put one's wealth. Since WWII median single-family home price adjusted for inflation (real price) was quite flat.

Nominal and Real (inflation-adjusted) national median single-family home prices since 1890 (data source: www.IrrationalExuberance.com).

The $250K tax break (passed into law in 1997 by Bill Clinton) was one of the causes of one of the greatest bubbles in U.S. history. For several years, the annual growth rate in the amount of houses in U.S. was almost twice the annual population growth. That's why it will take at least several years to clear that inventory surplus from the market. The house prices are very likely to fall below the historical "support" line in the real home price (see the chart above). In the following years, this may be an opportunity of a lifetime for many investors.

So, if you're going to invest in Real Estate, then watch the house market in your local area very closely. In about 3-5 moths from the time this article was written (May 2009) the real home price will be at the support level (the low of 1996-1997) in most regional RE markets. You can check the median prices of your local RE market here: standardandpoors.com.

Stocks and mutual funds

Stock market is a risky place to put money into. High volatility, countless conflicts of interests, stock frauds, accounting scandals, business-unfriendly government, double-taxation of dividends – all these make stock market a very dangerous place to keep money. The stock price of a carefully screened company, even if bought at a huge discount to the value of such company may stay below the purchase price for years. Even if the investor is right, the market may not reflect the true value of the company for years. Hence the saying: markets may stay irrational longer than you may stay solvent.

There are two ways to invest in stocks, which require two different kinds of analysis:

1. Investing in individual stocks
2. Investing in a stock market in general through mutual funds or exchange-traded funds

Investing in individual stocks may be quite rewarding. But it is only for professionals. According to the 10,000 rule you have to spend at least 10,000 hours of your life focusing on any activity to become a professional in that field. If stock investing is not your hobby, then you'll be better off staying away from the stock market. Very often the thoroughly investigated company turns out to be in some kind of trouble and very often dishonest management hides important information from investors, while liquidating their own holdings. There's a lot of dishonest but legal practices favoring the select few at the cost of the common stockholders. For example, the convertible bond arbitrage, naked short-selling, stock options, warrants, etc. Most experienced stock investors know how to spot such dangers and how to avoid them or at least minimize their impact. It's similar to professional boxing: you don't put boxing gloves on and enter the ring if you don't really know what to expect there. If you really believe that picking individual stocks is for you, then read at least the five books listed in the Books: Investing section.

Mutual funds are even more dangerous than investing in a portfolio of individually selected stocks. Most mutual funds charge excessive fees for their services. The mutual fund industry is full of dishonesty and conflicts of interests. It exists only because of the lack of education and knowledge on the part of those who invest in them. What makes matters worse, no investment professional is free of conflicts of interest, thus almost all professional advice and education materials for investors are heavily biased. That's why most of them suggest mutual funds and try to discourage picking individual stocks.

Although many people already know that it's better to avoid investing in mutual funds, the industry seem to be indestructible. Most 401(k) plans allow only to invest in a select mutual funds, thus keeping the industry alive. Over 90% of mutual funds underperform their benchmark indexes. Most mutual funds that beat their benchmark, are closed-end funds not available to new investors – many managers of such funds allow only several investors like close friends and family members, so their goals are closely aligned with their investor's. The mutual fund managers of the big mutual funds don't care about investor's return, because they are paid anyway in annual maintenance fees (about 1%-3% of total assets every year). All they care is not to lose their client's holdings all at once, because that would scare investors away. When adjusted for fees, taxes and inflation, historical mutual funds return is about 0%.

If you really want to invest in stocks, but you don't have time and knowledge to pick individual stocks, then ETFs are the way to go. Index funds, which are similar and (ETF – Exchange Traded Funds) offer the easiest way to invest in stocks. Most index funds and ETFs are managed by a computer, reducing management fees. The cost of holding shares of ETFs are usually well below 1% of total assets a year. The difference between mutual fund and ETF is that mutual fund shares (units) are priced once a day (on close), while ETF shares are traded on the market just like shares of any public company. This offers more liquidity and flexibility to investors. Some of the so-called professionals say that this encourages active trading and in the long-term it's bad for a regular investor. They seem to forget that the transaction fees are usually much smaller than front-end and redemption fees in mutual funds, which destroy much of investor's wealth. Also, ETF managers cannot freeze redemptions, investors don't have to worry about tax treatment of capital gains distributions, etc. The only thing investors have to worry about, is whether the stock market as a whole is over- or underpriced.

Historically stocks didn't perform as well as being pictured by media and the so-called financial professionals. One of the most commonly cited market benchmarks, the DJIA (Dow Jones Industrial Average) when adjusted for inflation didn't perform well all the time. There were several very long periods of time, when the purchasing power of the wealth invested in the stock market has shrunk significantly.

Nominal and Real (inflation-adjusted) Dow Jones Industrial Average (DJIA) index since 1896 (data source: Dow Jones Indexes).

Contrary to the popular opinion, stocks are not inflation-proof. During the inflationary period of the seventies stocks lost over 60% of the purchasing power while in nominal terms stocks were trading sideways. The purchasing power of a portfolio invested in blue-chip stocks in 1966 was 69.3% lower in 1982. Investor, who put money into shares of blue-chip stocks in 1966 had to wait until 1996 to fully recover the purchasing power of their money, earning nothing on the way. That's about 30-year period. Accounting for taxes and assuming 25-32% marginal tax rate, the owner of such portfolio would have to wait until 1998 to break even. This example assumes investing a lump sum in 1966 at the top of the market. Most investors however, are regularly saving and investing money over some period of time (for example for about 10-20 years) using dollar-cost-averaging method. In such case, the investor would break even more early (assuming he started investing in 1966), but exiting the market would require good market timing anyway, which is almost impossible to do. Also, not everyone can afford to wait additional decade to begin withdrawing money in retirement.

There are many similarities between current times and the seventies. The Vietnam War vs. the war in Iraq, the S&L failures vs. bank failures, the junk bonds vs. CDOs and MBS's, etc. Both periods of time are characterized by the government spending at astronomic levels, high taxes, countless new government regulations and overgrown government. What makes matters worse, the stock market entered the first decade of the 21'st century with historically high valuations (high PE ratio).

The only way stocks can outperform bonds in the following decade is by ever rising valuation of corporate earnings (rising PE ratio). The current PE ratio is already at high levels (in the 15-20 range). Corporate earnings are currently shrinking due to recession, but any rebound is quite unlikely due to business-unfriendly democratic government, rising taxes, loss of competitiveness by American companies and products on the global markets, etc. Due to corporate scancals and Wall Street excesses, the public distrust and resentment of stocks is on the rise, thus expecting the average PE ratio of the stock market to rise is just a fundamentally-unsupported speculation.

In summary, despite what financial professionals say, stocks are now a very dangerous place to put money into.

Bonds and CDs

Bonds seem to be a very underestimated investment vehicle. Over the last decade or two, because stocks proved to be always rising, stocks are not perceived by the public as risky as they should be. What is more, countless get-rich-quick-in-the-stock-market stories repeated by the financial media, created a view in the public mind that one may make money in stocks while bonds merely keep up with inflation.

Nominal and Real (inflation-adjusted) 1-year Treasury Bills performance (1962-2009) (data source: http://www.federalreserve.gov/releases/h15/data.htm).

During the inflationary seventies the purchasing power of 1-year Treasuries lost about 6% in the period 1973-1980, just to fully recover in the next two years. The compounded average growth rate of 1-year Treasury bills in the period 1962-2008 is about 5.96%. After adjusting for inflation, the compounded average growth rate drops to mere 1.69%. All that assuming no taxes were paid on interest earned. Assuming 25% marginal tax rate, the inflation-adjusted compounded annual growth rate is just 0.27%. That's about nothing, but in comparison to stocks these bills kept quite steady with inflation.

In the example above, the 1-year Treasury bills are used just to simplify the calculations. If such portfolio was invested in either government notes or bonds (higher yields but longer holding periods), it's performance would be much better. Also, much better yields were offered by corporate bonds. A tax-advantaged diversified portfolio invested in a mix of government and corporate debt in the long-term outperforms inflation by several percent annually (but below 10%) and offers a safe place to keep one's wealth.

Precious metals: gold and silver

The best-known precious metals are gold and silver. Other precious metals include palladium, platinum and other metals in the platinum group, but are not recognized an investment vehicle as widely as gold and silver. Historically, gold and silver were important as currency, but are now regarded mainly as investment and industrial commodities.

Gold

Gold is almost exclusively an investment metal. Almost all gold ever mined in human history is being held in bars, coins and jewelry. Very small amount of annual gold production is consumed in electronics, drugs, or even as a food additive. Some jewelry (low-carat) is bought for fashion, but most jewelry (high-carat) is purchased for investment as an alternative to buying bars and coins. Almost every ounce of gold that is held is potentially for sale at some price. The price of gold depends almost exclusively on the demand from investors.

Precious metals are perceived as valuable metals by almost all people on this planet and are used as a store of value by many. Except for several huge stockpiles of gold held by central banks, gold is held in small stockpiles among widely dispersed investors as a store of value. It should be noted, that a person using gold as a store of value will do so for a finite period of time. When such investor becomes aware of something that he needs more than gold, then he will sell it. Although all people are individuals, most people tend to think alike - it's called herd behavior. When a huge number of people sell gold at around the same time, then the price of gold may go and stay down even below production costs for years. That's what happened after gold price bubble in 1980. Since then up to around 2002, any long-term investment in gold lost the purchasing power.

Nominal and Real (inflation-adjusted) Monthly AVG London Gold Fixing since 1968 (data source: London Bullion Market Association).

After careful analysis of the gold price and the gold market, one may conclude that there is almost no connection between the price behavior and the fundamentals of supply and demand. Because amount of gold traded far exceeds the annual production and even the annual demand, one may assume that there is high possibility for market manipulation. One of the largest sellers of gold are currently large banks. The biggest banks are traders and even market makers in London Gold Market. This creates a conflict of interest. What is more, historically prices of any commodity tend to bubble and then bounce from the "support" line created by the production cost. In the long-term (10 or even 30 years) gold price will surely drop to that level. That would mean a drop of 70% in current money.

An interesting data of historical gold price can be downloaded from this site: MesuringWorth.org.

Silver

Despite what many people say, historically most currencies were based on the silver standard and not the gold standard. Many currencies were based on bimetallic standard (gold and silver).

Although silver is still considered by many people as an investment metal, most of the annual silver production goes to industrial applications. Silver is primarily an industrial metal. The price of silver depends heavily on the demand for products using silver and photography. Because about three quarters of silver is a co-product of copper, lead, zinc and gold mining, the silver price may be also heavily influenced by demand for these metals.

Nominal and Real (inflation-adjusted) Monthly AVG London Silver Fixing since 1968 (data source: London Bullion Market Association).

Reportedly, the 1980 spike in the silver price was caused by market manipulation by two American billionaires, Nelson Bunker Hunt and William Herbert Hunt known as the Hunt brothers. In early 1970s, they began accumulating large amounts of silver. By the end of 1979, they accumulated about 100 million ounces. Due to their trading activities, the price of silver rose from $11 and ounce in September 1979 to $50 an ounce in January 1980. The price collapsed, and the brothers went bankrupt.

The Hunt brothers are blamed for market manipulation in silver. However, no one is being blamed or even accused for any market manipulation in the gold market at the same time.

Since 1980, the inflation-adjusted silver price was in decline, bottoming in November 2001. In recent years the real price gained about three times in value. However, because the current price is about three times the production cost and because of recent developments in commodity markets, it can be concluded that the price is being manipulated. In the long-term the silver price will drop down again to the production cost level, which in current money is at about $2-$6 per troy ounce (depending on the mine). That would mean about 70-80% loss in purchasing power.

Conclusions

Precious metals are used by investors as a storage for the value of money. This is most probably caused by fundamentally unsupported general belief, that the market value of precious metals keeps well with inflation. However, the price behavior of gold and silver proves that this is not a safe place to put money into.

The capital gains tax applies when precious metals are sold for profit. Even if the gain exceeds the impact of inflation, the after-tax real return on investment can still be negative.

Investing in gold and silver should be avoided by most investors. Much safer place to put money into are Real Estate and bonds.

Collectibles and art

The general belief is that collectible items and pieces of art will only increase in value whit time. These include anything in between paintings of great artists, bottles of old wine or whiskey, baseball cards, and even Star Wars action figures. Almost anything can become a callectable item. The market value of such items tend to fluctuate depending on the "collectible crazes". In general investors should avoid buying anything that's already a collectible item, because it's price is already very high. What is more, most valuable collectible items require maintenance and a designated place to keep it. Often the maintenance and storage costs may be quite high. Collectibles don't pay dividends and usually have negative cash-flow (maintenance and storage).