In this article we provide a simple, high-level discussion of various financial assets
including stocks, bonds, precious metals, and cryptocurrencies.
This simple view is enough to get a feel for why these assets change in value over time and
the risks and benefits of buying / holding them.
Stocks
Shares of stock represent partial ownership of a corporation.
Just as a car title states who owns a car, shares of Google state who owns
that fraction of the company.
Shareholders are entitled to steer the company by
voting in corporate elections and
receive a share of company profits.
Corporations use labor / material to produce goods / services.
Successful corporations earn
profit that can be distributed to shareholders via some combination of dividend payments,
buybacks or increased market cap.
Figure 1 - Profits from Corportation X are used to reward shareholders and reinvested to increase future profits.
The average company increases profit over time by becoming more efficient or productive.
For example, Apple nearly
doubled the number of iPhones sold each year from 2008 to 2012.
This explains why shareholders can expect to earn compound interest on shares owned—better than earning a fixed dollar amount each year.
Of course, some companies fail to earn profit on their goods / services.
This can be tolerated to an extent.
If the company has enough potential for future profit, investors will provide capital to
keep the company afloat, in exchange for a piece of future profits.
Eventually, many companies will fail to earn profit or even convince investors to keep them alive.
This normally puts selling pressure on the shares of stock, causing the price to decline.
At some point, the company may
extinguish its resources and credit, forcing it into bankruptcy.
In this case, shareholders lose most or all of their investment
(common stock shareholders are last in line to receive any company assets after closure).
As you can see, holding stock of successful corporations naturally provides compound interest, but
holding stock of failing corporations can result in complete loss.
Unfortunately, predicting which companies will succeed and fail has proven elusive to
even the top business and technology experts.
Given this, and the fact that the average company will earn a respectable compound interest,
the wisest (and easiest) thing may be to buy and hold market-cap weighted index funds like
VT.
For more information on this, see our article:
"Should you try to beat the market?"
Gold and precious metals
Unlike shares in a company, gold does not produce anything. An ounce of gold today will still be an ounce of gold 10 years from now and nothing else.
This has benefits and drawbacks. Benefits include the inability to fail or vanish (like a company issuing stock), and
the unlikelihood of a sudden increase in the amount (supply) of gold relative to fiat or other assets. The main drawback is that it doesn’t create value.
Unlike companies or farm land, gold bars don’t produce new things of value (two gold bars don’t make gold babies!).
Precious metals have industrial uses (see this),
but these typically account for a small fraction of their trading value.
The dominant factor in the trading value of gold is simply the fact that many people believe they can trade it for
another asset (e.g. fiat currency) in the future.
Some people claim the inability to price a precious metal relative to its properties is a drawback.
An investor can estimate a fair value for a share of stock by reviewing the number of shares, earnings, debt and so on.
He can decide that he wants to buy GM because it’s very likely it will profit 10 USD next year for each 100 USD he spends on shares
(of course, there is no guarantee, but typically such estimates can be made with reasonable assumptions).
There are no such estimates for gold. If the price of gold doubles tomorrow, should we buy or is it a rip-off?
Other Commodities
Commodities like oil or cattle derive value from enabling the production of other goods.
They are typically not reusable,
and many do not create new value (e.g. two drops of oil don’t create a third drop of oil).
Hence, they do not have this fundamental reason for exponential growth, like stocks.
However, they have the potential to
increase value when if demand surges.
In our world of fixed / limited resources, you may expect this to be the case
most of the time. However, human ingenuity often works around this.
People tend to find ways to reduce or even eliminate the need for resources over time,
particularly if they are expensive.
For example, cars have become much more fuel efficient, and they're on pace
to not use oil / gas at all in the future.
Figure 2 - Commodities are purchased and later sold to earn a profit.
The same principle applies to precious metals. Although physical wood is shown, people typically don't take / deliver the
physical commodity. Instead, a ledger entry is added to indicate a change of ownership (physical storage is unchanged).
Fiat Currency
Fiat currency is typically the most useful asset for trade. Your employer trades your work for it, then you trade it for food,
shelter, transportation, entertainment, and other assets. For this reason, holding a certain amount of fiat is necessary.
Beyond that, fiat doesn’t have good properties. It doesn’t grow value like a successful company or farmland, and its
supply is not constrained like Bitcoin or gold. In fact, central banks have caused hyperinflation several times by
increasing the supply of fiat too fast. A famous example is the
Weimar Republic in the early 1920s.
Cryptocurrency
Cryptocurrencies like Bitcoin are somewhere between gold and fiat currency. Some, including Bitcoin, have the advantage of a fixed supply limit.
This limit is more constrained than gold—a new gold mine or technology could radically increase its supply. However, it must
be pointed out that the total supply of all cryptocurrencies is not limited—it can change on a whim.
Another advantage Bitcoin has over precious metals is the ease of storage and transfer.
Anyone who has bought and sold physical gold can tell you it’s not convenient and often results in a significant
loss, having to buy at a premium from a dealer, potentially pay for secure storage, and sell at a discount.
(Even “paper gold” includes fees for storage, administration, etc.)
On the downside, Bitcoin doesn’t create new value and is reliant on people’s belief for its
current value. Worse, you can’t make jewelry or anything out of Bitcoin—there’s no “backup source of value” to
support the price if speculators lose interest.
Some people feel less comfortable owning Bitcoin, compared to a similar asset like gold.
Bitcoin’s short history is partially to blame—it’s only been in existence for a decade.
Gold has held speculative value for thousands of years. Also, security mechanisms protecting Bitcoin are not well
understood by most people. Your grandfather may feel comfortable sitting in front of his gold safe with his gun,
but not putting money into Bitcoins housed in an internet-connected exchange
(or even storing a “mysterious” Bitcoin key or wallet offline).
Bonds
A bond is a contract in which the investor lends money to the issuer, with the expectation
that the money be paid back over time with interest. The issuer will typically use that money
in some productive pursuit, like building a road or hiring a software engineer. The issuer will
typically earn money in this pursuit (e.g. by taxes in the case of governments) and use that
money to pay the investor. This is why, like stocks and farmland, it’s reasonable for a bond
investor to receive compound interest over time. Of course, some issuers will fail in their
pursuits and be unable to pay the investor. In this case, the investor may not receive the
expected repayments and could lose significant money. In some cases, the issuer will be dissolved,
and their assets liquidated to at least partially reimburse bondholders and others.
Figure 3 - When you buy a bond you are loaning money to the seller / issuer.
If things go well, the issuer will use this money to earn even more money, which they can use to
pay you back with interest.
Summary by analogy
Here’s a summary with analogies.
Owning a stock is like owning a machine that can potentially create money at an increasing rate over time. Some of these machines will not produce much or even break, leading to partial or complete loss of investment.
An equity index fund provides partial ownership of many such machines, e.g. 500 for VOO. Even if some of these machines fail, the investor can be successful if the average machine continues to create money at an increasing rate.
Bonds share many properties with stocks, but the performance of the “machine” is more predictable: it’s less likely to underperform but also less likely to overperform. They can still fail, but you’re more likely to recoup some of your investment by reselling parts.
Commodities are analogous to the components used to make the machines. If they become scarce and are still needed to make the machines they can appreciate, but often humans will find another way to make the machines, avoiding expensive/appreciating commodities.
Precious metals are the decorations on the wall in the machine room. These decorations have remained on the wall for thousands of years while hundreds of thousands of machines have been created, failed and replaced. They can’t fail, but they don’t create anything either. They don’t help the machines much, but the workers like them and are willing to buy them. If the workers lose their taste for these decorations, they could completely lose their value.
