Teardown: The Only Two Ways Your Money Can Grow and Choosing a Strategy
Reading Time: 7 Minutes
When I was just starting out, I read pretty voraciously about how to invest and where I should put my money. The advice is varied and often piecemeal. For a few years, I dumped my money into a Fidelity target fund. It gave me an allocation of stocks and bonds based on my target retirement age. Excellent, I thought. Someone really smart is going to figure out what I should do with my money.
I now call those years the Dark Years, characterized by below benchmark returns and a total lack of understanding of why my own money was being put to work in different asset classes.
On the bright side, it forced me to clarify what my goals and needs were, and to realign everything I had learned piecemeal about investing into a cohesive framework. It turns out the framework is very simple. There are only two ways investing can grow your money, and they have very distinct positives and negatives that you can evaluate to fit your needs.
So forget rules of thumb like “your age in bonds”. You can develop your own framework and your own allocation.
You think something is going to go up in value over the next few years. Getting in now on the ground floor is going to yield a huge payout down the road. So you pony up the cash, tie it up in the opportunity, and check back for your payout in a few years.
This is the appreciation strategy.
You care very little about what happens in the interim between Time A and Time B. Just that by the times you sell it, it is worth gobs more than what you paid for it.
You’d like to see regular payouts each year and make your money slowly and steadily. Each month, quarter, or year should bring a check in the mail.
This is the income strategy.
If the appreciation strategy only looks at Time A and Time B, the income strategy cares about Time A1, Time A2,Time A3, and so on until Time B. The benefit is that with regular infusions of cash, you can turn around and have more spending power each year, or more investing power by deploying that cash into new opportunities.
This is especially important to folks who are already retired and depending on their nest egg for a steady stream of cash to pay their annual expenses.
The Major Asset Classes
All three major asset classes – stocks, bonds, and real estate – can be used for either strategy above. They all grow through both components. However, you are generally betting on one or the other to carry the bulk of your returns.
Stocks – While there is a contingent of folks who try and buy value-based stocks for their dividend stream, the vast majority of investors buy stock for the potential of appreciation. The S&P currently delivers a 2.05% dividend yield. You have doubtless heard about how investing in the stockm market long-term has historically yielded 10%+ returns. The majority of historical returns has been appreciation.
Bonds – Professionals who study the cyclicality of bond markets and the interplay of stock and bond performance may try and aim for appreciation, but the majority of us turn to bonds when we are looking for fixed income – a steady stream of annual cash flows. That is because for appreciation, historically there have been other asset classes (namely, stocks) that have performed better on appreciation; if we wanted an appreciation strategy but don’t have an edge, we would go elsewhere where there is better appreciation performance.
Real Estate – This is the trickiest one. I would say there are sizable camps for both strategies with real estate. You hear about speculators buying up properties or land – this is an appreciation strategy. You read about being a landlord and collecting a nice passive rental check every month – this is an income-based focus, with the hope you also realize some appreciation when you finally sell the property. Real estate is a local market, which means that if you are in California and getting advice from your Aunt in Arizona, you may have two very different pictures of what one can expect from appreciation. Check out the charts below.
US Housing Price Appreciation – 10 Years
Chart courtesy of Brian Larrabee
Essentially with a real estate strategy, the local market you are in determines whether you will be generating more from cash flowing as a landlord or betting on appreciation. Bigger Pockets does a nice job of illustrating that here and in the charts below. If you’re in San Jose, CA, the math is unlikely to make landlording attractive on its own and it’s the appreciation you are gunning for. In Memphis, TN, being a landlord gets you within breathing distance of 10% annual-rent-to-home-value ratios.
Charts from Bigger Pockets’ 2015 Real Estate Market Index.
Choosing A Strategy
We all would like the highest return with the lowest risk. The reality of our options is that appreciation strategies tend to be higher risk but higher reward, and income strategies tend to be lower risk but lower reward. But the quantum of those numbers matters a lot, and they have not been stagnant throughout the years.
For someone who still has 6-10+ years ahead of them before retirement, I honestly see no benefit to having any bond portfolio at all. As a full-time worker, you don’t value the consistent income. Many experts suggest bonds to reduce volatility, but this only makes sense if you are being sufficiently compensated for your troubles. A 20% allocation in bonds for a 25 year-old might have made sense when bonds were yielding 5-6%. 20% of his portfolio would truck along at 5-6%. Perhaps you want some money in a different asset class to buy stocks on sale. I could see an argument for that.
But today, the 10-year treasury is yielding just under 1.8%. Meanwhile, last month’s YoY inflation was 1.5%, so you are basically making nothing for your troubles in real dollars. On top of that, you are taking principle risk.
Source: CNBC Quotes
In the past year, 10 Yr treasury notes have eroded 14.5% in price. That means if you were to sell your notes just like you would sell your stocks, you would have lost 14.5% on your money while collecting interest that just barely keeps up with inflation.
Part of my strategy as an early retiree is to have a fixed income portion to my portfolio. But given the current yields for bonds, I don’t deem the risk worth the reward. I still have some potential profit interests coming from my old employer that can tide me over for a few years’ of ongoing expenses without touching my nest egg. As such, given my needs I’m choosing a strategy focused on appreciation and focused heavily on stocks for the time being.
What about you?