Investing 101 Part IV: The 3 Asset Classes
by Alex mason
Our attention now turns to the universe of investment options. These are called asset classes. They are places we can put our money with the expectation that they will produce some kind of financial return for us.
We’ve seen that assets we should focus on as investors are oriented toward growth, toward income, or both. What about specific types of investments, and where do we go from here? Thinking about asset classes from a different perspective will help us hone in on what specific types of investments we should consider.
There are many different types of assets, but broadly speaking, there are three things we can invest in: private businesses, real assets, and paper assets.
The first asset class is private businesses. If your sister-in-law wants to open up a consulting firm and asks for money to help start it up, you might put up some money with the hope that the business prospers and, as an owner, you would reap the benefit of an increase in value.
The scenario would be the same if you wanted to invest in a local bagel shop or dental office. Entrepreneurs need capital, and instead of taking out a loan from a bank, they might sell a part of their business to you in the form of equity. Equity equals ownership. In this case, as the investor, you’re not counting on a loan being paid back. You own a percentage of the business, which means that legally you’re entitled to your share of both the profits and losses of that business over time.
- Some sub-groups of this asset class include:
- Start-ups (venture capital/angel investing)
- Established private businesses
Investing in private businesses is usually best suited for people who already have some wealth and are looking to expand through higher risk, higher reward ventures. For example, there are groups of people called angel investors who invest in start-ups (i.e. unproven business ideas that aren’t making money yet).
Private equity investors buy shares in privately held, established businesses. An example of this is Warren Buffet. His company, Berkshire Hathaway, is a public company, and many people think of Buffet as someone who is a world-class stock picker, which he is. However, a common misconception is that this billionaire built his wealth exclusively through stocks, which is far from the truth. Buffet has spent much of his career looking for private businesses to buy. One example was his purchase of See’s Candies, a chocolate and candy maker from California.
There are ways to participate in this asset class without having lots of money already. For example, you could buy shares of a private equity fund or venture capital fund, which just means that you pool your money with other investors in order to buy private businesses. Take note that investing in funds like these requires you to pay a management fee to whoever is running the fund.
Probably the most common way to invest in this asset class, outside of founding your own company from scratch, is to invest in a franchise. A franchise is a network of businesses that share a common brand name and functional operations. They’re just run by different people, usually in different regions or territories.
An example of a franchise is McDonalds [link to stockstoryteller.com/mcd]. Although the large corporation we know of as McDonalds creates burger recipes, sources ingredients from farmers, and runs ad campaigns, the local McDonalds near where you live is actually owned by someone other than McDonalds the corporation. At some point, this person or group of people applied to the corporation to be a franchisee, paid an upfront fee to open their location, and now pay ongoing royalty fees that are a percentage of how much business they generate.
In exchange for paying all these fees, the franchise owner gets to use the McDonalds brand name to sell burgers and fries, which often makes it an attractive proposition given that McDonalds is one of (if not the) most successful restaurant concepts ever created.
Restaurants aren’t the only types of franchises; there are many more: dog grooming businesses, child care businesses, elder care businesses, car washes – the list goes on.
Private Businesses - Major Benefits and Drawbacks
The biggest benefit of investing in private businesses is the potential for very high rates of return. To use another example, it would not be uncommon for a typical Domino’s Pizza business to generate over $100,000 per year in profits. Consider that to start a Domino’s franchise costs somewhere between $200,000 and $500,000, and you’re talking about a potentially very large return on your money.
The biggest drawback of buying a private business is the higher amount of money and risk usually associated with these types of investments. It is also a step closer to entrepreneurship (and in the case of owning and operating a franchise, is entrepreneurship) and can require lots of time depending on the opportunity. For example, an angel investor who buys shares in a start-up company might invest $100,000 and never see a return on that investment at all, after spending dozens of hours evaluating the company, talking with the founder(s), etc.
The second category is real assets. Real assets are anything physical that you or I can see or touch that has value. The most common example of a real asset is real estate, which itself has many subcategories such as residential homes, commercial office buildings, and apartment complexes. The categories of real assets can include:
- Real Estate
- Precious Metals (Gold, Silver, etc.)
- Commodities (soybeans, oil, etc.)
- Collectibles (artwork, classic cars, etc.)
Real Assets – Major Benefits and Drawbacks
Real assets are the original way that humans built wealth and stored value. In Medieval Europe, pepper was a commodity that was considered so valuable, it was owned only by kings and nobility [link to stockstoryteller.com/mkc].
In the early days of America’s founding, real estate was the way that wealth was created and passed down, with large tracts of land given to early settlers by European colonizers. Entire class and social structures were formed and cemented by real estate ownership, with White, male plantation owners reaping the benefits of dozens of acres of land worked by African slaves who had no ownership at all.
A major benefit of real assets is that they usually have some obvious physical utility. A house is something you can live in for shelter. Farmland can be planted with seed to grow crops. Artwork is considered beautiful or aesthetically pleasing. They are tangible things that can be seen and touched.
Real estate, as a general asset class, has made a lot of wealth for a lot of people. Single family homes, warehouses, strip malls, mobile homes, and office complexes all allow modern civilization to thrive because of the physical benefits they provide. There is a certain stability that is attractive to this asset class, particularly residential homes. No matter how technology evolves or how the economy moves, there is some logic to the belief that people will always need a physical place to live.
On the downside, real assets are not scalable and are finite resources. If you want to sell more barrels of oil, you have to go searching for it, drill for it, transport it, refine it, and then sell it as fuel. If you want to become a real estate investor and rent a single-family home to a local family, you can only rent out that home to one group of people at a time. If you want to collect 10 times the rent, you’ll need 10 times the units, and that can take a lot of time and physical labor, let alone the money required to purchase the additional properties.
The third and final category of assets you can invest in is paper assets. Paper assets are things that have value but that we can’t see or touch. The subcategories within this asset class are numerous, and will only become more so as digital technology, artificial intelligence and the internet become more sophisticated. These include:
- Currency (U.S. dollar, Mexican peso, Bitcoin, Ethereum, etc.)
- Intellectual Property (Software, Patent Rights, Music Royalties, etc.)
Some types of paper assets stand alone and are created by governments or other organizations (like currency). Others derive their value from one of the other two asset classes. As an example, a share of stock represents a business, which itself owns assets. Mineral rights for land out in Texas may derive its value from the fact that it is a contract allowing you to drill for oil (a real asset) within certain physical boundaries of the property.
Paper Assets – Major Benefits and Drawback
The beauty of paper assets is that their value is based on intangibles, which is what makes them scalable. That means that their theoretical value has a much higher limit than for real assets, which are more tied to physical utility. A single, well developed software platform can serve billions of people instantaneously (i.e. Google), in a way that a strip mall in a typical suburb cannot. Shares of stock can be used as the paper asset that represents ownership of scalable businesses, making them attractive for investors.
Paper assets are also attractive because, once created, they require little to no work for the owner to reap financial benefits. Once a patent for an invention is created and licensed out for use by others, as long as the invention remains relevant and salable it will continue to generate royalties for the patent owner long after the invention itself was conceived.
A major downside of paper assets is that they cannot immediately take care of your physical needs or desires. They are representations of ideas and ownership. You can live in your stock portfolio or eat your collection bonds. This type of asset may also be at higher risk of regulatory scrutiny, depending on its specific characteristics (ex. cryptocurrency right now).
Why I Primarily Invest In Paper Assets
We’ve looked at the universe of investments from the perspective of growth and income as well as private business/real asset/paper asset. Though I like all three asset classes and will eventually invest in all of them, at this phase of my investing journey I’m more focused on paper assets.
In spite of its drawbacks, I think paper assets are most suitable to beginners and advanced investor alike because they are:
- Low barriers to entry (i.e. little to no commission to buy or sell)
- Often have liquid markets, allowing you to buy and sell more quickly
- Have many options that can generate high rates of return
- Don’t require hands-on management
In Part V, we’ll look at a specific type of paper asset – company stock – and learn more about its characteristics and why it can make an attractive investment on your journey toward financial freedom.