Saturday, August 10, 2019

Three main types of assets to manage: Part 2 of 3

Three main types of assets to manage: Part 2 of 3

The second of three asset types you need to manage are liquid assets that are part of your personal balance sheet. As mentioned in the first part of this series, the main point of the series is that each asset has a net present value, and that the balance between them shifts throughout life as you use one type of asset to gain another. Long term success depends on an understanding of the three asset types and how to balance them.

What are liquid assets anyway?

Liquid asset are those asset that you can easily convert from one form to another. Cash, stocks with high trading volumes, exchange traded funds, and bonds etc. As a rule of thumb, if it takes less than a day or two to convert the asset from one type to another, it is a liquid asset.

I will not go in depth into each type of liquid asset, but in sum:

  • Stocks are very volatile and their price more often reflects underlying market sentiment than their "real" value (by that I mean their ability to generate and return capital to shareholders over the company's lifetime).
  • Bonds are risky in low interest rate environments and are generally not a good protection against inflation. Besides, your salary is your fixed income. Only buy bonds if you are in need of a mental cushioning.
  • Cash is shit. Absolutely useless to hold. Get it working for you as soon as possible (either through rent generation or experience generation (aka having fun)).

How should you invest in liquid assets?

I am a big fan of ETFs and low cost funds for one simple reason: to generate an alpha has an alternative cost. It costs both time and money to do research on stocks and trying to find market beating performers. Let us ignore the fact that most professional investors fail to beat the market over time and that most average investors fail to generate a positive alpha. 


Back to the alternative cost ... say that you start with a portfolio of KSEK 100 (which is the median net worth of a 35 year old Avanza customer). Assume that you generate a Peter Lynch level alpha of 15% (compared with SP500 dividends reinvested), which you won't. Let us compare this with boosting your annual income with KSEK 50 and 100 respectively (numbers are inflation adjusted).



Using the 1977-1990 numbers, it would have taken you 13 years of Lynch performance (i.e., his entire investment career at Fidelity) to beat a strategy where you simply worked for KSEK 50 more annually and invested that money into a simple index fund. I would argue that it is a lot easier to earn KSEK 50 more annually than it is to be Peter Lynch. 

Another way to phrase the above, is to say that you would need a portfolio size of KSEK 423 before you should consider attempting Peter Lynch level returns (at that level you are growing your portfolio with KSEK 97) over simply trying to earn an extra KSEK 50 over the SP500 return. At KSEK 100 extra annually, you should not attempt to be Peter Lynch until you have at least KSEK 1'187 in your investment portfolio. And if we consider that the median 50 year old Swede at Avanza had KSEK 173 in their stock accounts, you are not very likely to ever have stock holdings at a size that would justify you attempting to become one of the greatest market investors of all time.

The idea to work extra and move that income into stocks is effectively equivalent with you transferring your human capital into liquid assets.

Next time, I will explain what the third asset type is and why I prefer to invest in it.

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