- In his search for safety, the average investor usually does it all wrong.
- Stocks, bonds, real estate, gold, and cash will all probably drop more than 70% once in your lifetime.
- However, there is an asset class that is much safer and will lead to huge returns, Buffett would call it a “bet on America.”
When I talk to people that aren’t as obsessed about investments as I am, a word that I constantly hear is “safety.” Everybody wants to do something with their capital without risk and they are in a constant inner fight related to their money and what to do with it.
Very few of us sit down for a few hours every day to educate ourselves about the risks and rewards of investing. Then, after seeing how others make money in the stock market, real estate, or other asset classes, they jump in with all their savings. This usually happens at or close to market peaks and the end result is miserable.
In the last 20 years, the average investor achieved average yearly returns of 2.3% while the market returned 7.7% and inflation was 2.1%.
Figure 1: Returns achieved by the average investor are terrible. Source: J.P. Morgan (JPM).
But why does the average investor perform so badly? There are many reasons but the main one is psychological. We humans usually get quickly irritated by something we don’t understand properly and don’t invest the necessary time to learn about the subject. However at some point in time, usually after a few bull market years, everybody else is investing in the latest hottest asset class. Then even the most defensive investors lower their guard and feel compelled to invest as well. Unfortunately, when it comes to investments, this is the worst way to behave.
On top of it, as the prospect theory explains, people have to see gains before they invest, and nobody is going to invest in the midst of a bear market or market bottom. We can say that the average investor is greedy when others are greedy and fearful when others are fearful. Such behavior is normal, but leads to terrible investing results.
So where would I suggest average investors put their money? What is the safest asset class? I’ll answer these questions in today’s article.
Every Asset Class Will Drop 70% Or More Once In Your Lifetime
Ray Dalio, the legendary hedge fund manager, has for some reason stopped reminding people that every single asset class will probably drop 70% once in our lifetimes. I assume he stopped telling people this because people don’t like to hear such a statement. However, it’s the truth. Let me show you a few examples.
I’ll start with stocks. If we look back 90 years, thus a lifetime, we can see that there have been plenty of bear markets and the largest downturn was 86% in the 1930s.
Figure 2: Bear markets happen every 10 years. Source: JPM.
In 1937, stocks dropped 60%, 1946 30%, 1961 28%, 1968 36%, 1973 48%, 1980 27%, 1987 34%, 2000 49%, and 2009 57%. Therefore, everyone who invests in stocks should know that on average, every 10 years the stock market drops more than 20%, or 45% on average. Thus, stocks aren’t a safe investment at all. Unfortunately, few understand this or maybe just don’t want to see it.
You might think bonds are safe. Well, short term bonds are like cash, however the bond issuer can always default, especially countries that are mounting up deficits year after year. I wonder what country might that be…
On top of the default risk, there is always the risk of interest rate increases on longer term bonds. An interest rate increase of 100% seems huge, but in many cases that would be a jump from 2% to 4%. This would lower the value of a bond by 50%. For example, those who invested in 30-year bonds are on a rollercoaster.
Figure 3: Yield on Italian 30-year government bond in the last 5 years. Source: Bloomberg.
Another current paradigm is that real estate is an extremely safe investment as prices can’t drop. I’ll show you two examples. The first is from the last recession where real estate prices dropped 27%.
Figure 4: Home price dropped 27% in the last recession. Source: FRED.
Going back to the Great Depression, it’s easy to find price drops of more than 70% from peak to bottom but in general, real estate prices dropped 50%.
Figure 5: Real estate prices during the Great Depression. Source: Real Estate Economics.
So if stocks, bonds, and real estate aren’t safe, is gold perhaps the safest asset?
Not at all, gold has been incredibly volatile since currencies were unpegged from it.
Figure 6: The price of gold is very volatile and large drops are common. Source: FRED.
Now, if stocks, bonds, real estate, and gold aren’t safe, then cash has to be the safest asset. You can’t go wrong with cash, can you?
Well, depending on how you look at it, cash is the least safe asset of all. What I can buy today for $100, I could have bought in 1979 for $30, that’s a 70% loss.
Figure 7: From $30 in 1979 to $100 today. Source: Inflation Calculator.
So what’s the safest investment class and how can you build the best portfolio? Well, that’s the million-dollar question, or rather the $3.36 million-dollar question as that’s what a million dollars was worth back in 1979.
However, there are a few things you can control and a few things you can be certain of.
What you can control is the price you pay for something. Therein lies the greatest safety.
The lower the price you are paying for something, the lower the risk and the higher the upside. It is as simple as that.
Further, you can control what you buy. For example, if you buy a share of Tesla Motors (NASDAQ: TSLA) now, you need a lot of things to run smoothly in the next 5 years to make a profit on the investment. By profit I mean real returns from earnings, not from speculative trading. But if you buy companies like Berkshire Hathaway (NYSE: BRK.A, BRK.B), you can be pretty certain that such an investment will deliver satisfying returns over the long term. Again, the lower the price you pay fundamentally speaking, the higher your investment return will be and the lower the risk.
What you can’t control, but can be pretty certain of, is that the human race will evolve and the economy will grow. Therefore, if you bet on the American, Chinese, Indian, or European economy, rest assured that you will do fine in the long term. If you can do it when the cost of such an investment is low, even better.
Of course in the short term, even a bet on America can go sour, but if you invest, you must always do it for the long term and know that the underlying earnings of the investments will determine your returns. If you know the earnings you are buying, are happy with the earnings yield, and invest for the long term, you’ll be safe. On top of it, if the prices of such stable investments fall, you can just buy more!
Keep reading Investiv Daily as we’ll soon discuss the best portfolio allocation for the current environment.