How is your summer going? The AoF family is just back from another successful RV holiday, and it’s been our second to-date in the last few years.
RVs seem to have an almost mystical appeal in the FIRE community and I wouldn’t say I’ve jumped on the bandwagon, but I’ve certainly craned my neck as the bandwagon flashed past. I’m not sure I will fully jump aboard but here are my learnings:
- The kids are not that keen on RV travel. They’ll tolerate it for a couple of weeks, but no misty-eyed visions of freedom on the open road from them, and so I think this will be a predominantly post-kids activity.
- I hate driving large RVs. Let me clarify; driving is fine, it’s just the maneuvering that sets me on edge. I just can’t stand the tension of not knowing when the next disastrously costly event will happen. I guess you can say that about life in general, but RVs seem to heighten that tension for me.
- We much prefer state and national park campgrounds to private sites. They are much quieter and the basic down-to-nature feel seems to attract a different crowd.
Comment below to let me know your RV/trailer experiences, but let’s now get onto business…
What Is an Investment?
There is quite a degree of discussion (ahem… argument) in the FIRE community about different investments and what makes the best investment.
We’ve all seen and heard from lovers of dividend stocks and rental properties. You also don’t have to go far to come across Bitcoin fanboys/girls, Vanguard nuts and people on both sides of the Treasury bond debate (see my two posts on investing in long duration STRIPs; post 1 and post 2).
Everyone has their corner that they want to defend and persuade others to join, but I’ve seen little on the philosophical framework for – How should we think about investments?
The personal finance community would do well to step back and understand a framework that helps to understand where these differences in viewpoint lie.
And there are only two questions you need to ask to understand how people view a particular investment.
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The two questions you need to ask are:
- How efficient is the market?
- Is there an obvious risk premium?
Urgh! Jargon alert!
There’s nothing I loathe more than investment jargon, it’s usually deployed by those seeking to brow-beat others and signal their un-earned superiority. So let’s break this down and make it simple.
Cutting Through the Crap on Market Efficiency
When we talk about how efficient a market is, we are assessing whether there is a high degree of transparency in the pricing of the investment and whether there are many buyers and sellers that can transact with low costs.
A good example is groceries. There are many grocery chains willing to supply your groceries and many buyers that can purchase groceries in an easily accessible way. The prices are transparent, the goods are consistent and we are free to shop around. Under my definition this an efficient market.
If you are a fairly standard personal investor with a pretty standard knowledge of the investment markets then I’m also gonna say that the stock and bond markets are efficient. These mainstream markets are widely traded everyday with billions of dollars of flow and from your (and my) point of view the market price for stocks and bonds is a fair reflection of the value that the market has placed on them.
But what about a market that is not efficient? A good example is your local housing market for residential properties. The buyers and sellers are limited and the costs for a property transaction are relatively high. This is also a market where you may have knowledge that other investors from out of town may lack. There is no doubt that the internet has made property pricing more transparent but due to the above points it will always be quite inefficient.
Cutting Through the Crap on Risk Premium
Why do we invest? And what is an investment?
If we take a $50 dollar bill and exchange it for an investment then we hope that over time we will earn a return on that money. This return might take the form of periodic payments (dividends or bond coupons) or we may hope the investment appreciates in value so that we can sell it in the future for more than $50. This return is rarely certain and there may be chance that our investment falls in value or we lose the full $50.
But why should you expect a return on your investment?
You can only expect a return if there is a risk premium involved, and the risk premium is the reward to the investor for handing over the $50 bill. The risk premium is not guaranteed but there must be some inducement from the seller of the investment to get you to part with your money.
Some examples will make this clearer.
- If I ask you to lend me $50 to pay for some of the damage I’ve wrought to my RV I might offer to pay you back $55 in six months’ time. There is a clear benefit to me in getting hold of your capital and there is a clear inducement to you in lending it to me.
- I’m going to be setting up an RV maneuvering school. Since I must make some initial purchases I need some startup capital and I’m going to offer you a share of the company for $50. This enterprise will be hugely successful, and I might pay you some dividends from the future profits and you will own a share of a rapidly growing company. Again, you can see the benefit in the transfer of capital and the inducement to the investor.
In both cases there is a clear risk premium attached to the investments. There is no guarantee of return but there is an obvious transfer of capital and reward inducement.
It’s no accident that the equity and debt markets (stocks and bonds) have become the most efficient markets available for making investments. If you have capital to deploy, then these markets are the best way to make an investment and earn a risk premium.
Classifying the Options
You might ask; what about when markets are not efficient, or when there is not an obvious risk premium?
Let’s look at all the possible combinations and analyze them one by one.
A Clear Risk Premium
Investments that have a clear risk premium are quite easy to identify. We’ve already discussed stocks and bonds. These are instruments that can pay a return in exchange for your investment.
A special note should be given to Treasury bonds. These are essentially risk-free in the sense that they are very unlikely to default, but they still have a risk premium. This mostly comes from the fact that you are taking inflation risk by lending to the US Government. Yes, you will get your money back, but inflation will erode that return. Hence the Treasury bond still has a “risk premium” even though you might think it riskless.
If you believe the market is efficient then by definition you do not believe there are any pricing disjoints that you could exploit. However it’s still possible to earn a return from an investment with a risk premium. This leads you to the conclusion that you should simply hold the investment in a passive way since the market is efficient and active security management is a losing game in an efficient market.
Recommend passive management when there is a clear risk premium and efficient market
If on the other hand you believe a market a particular investment with a risk premium has inefficiencies then active management is definitely worth it. An example here are rental properties. These have a risk premium in that you lend your capital to another in the form of the use of your house, and in return you receive rental income. It’s analogous to a bond, where you lend money to an institution, and in return you receive regular coupons.
The residential rental market is also inefficient since there are limited buyers (landlords) and sellers (tenants), and rents are idiosyncratic.
If you have an ‘edge’ in an inefficient market through superior knowledge then it’s preferable to actively manage your investments. (Note that I’m conveniently ignoring any frictional cost differences between active and passive management. In my example holding a number of rental properties may be much more inconvenient and cumbersome than just passively buying a share of a large national rental company.)
Recommend active management when there is a clear risk premium and an inefficient market
These observations lead you to the following summary for investments that have a clear risk premium.
No Clear Risk Premium
What if there is no clear risk premium and the market is efficient?
There are a number of activities or ‘investments’ that have no clear risk premium. Many games of chance like roulette or the lottery have no risk premium. If you hand over your $50 bill there is no expectation of earning a return from that money. You can argue that the lottery has a very small risk premium in that the expected winnings are slightly above zero, and roulette has a negative risk premium since the house wins on 00. They are also efficient markets in that the rules are clear and there is perfect information between all the players
So activities that have an efficient market with no risk premium are classified as gambling. But not all gambling happens in an efficient market.
Activity is gambling when there is no clear risk premium and an efficient market
There are inefficient markets for ‘investments’ with no risk premium. These would include card games, sports gambling and I’m going to classify Bitcoin in this group. All these activities have no expectation of return but have incomplete information to the participants. Playing poker is often described as a game of skill since a player will have information that is known only to them and might be able to use that as an edge.
It’s not too contentious to say that in fact all commodities have no risk premium, and this includes Bitcoins and property. If you exchange your $50 note for $50 of gold or $50 of oil or a $50 house, then you have simply bought a good with the same value as your cash. You have not made an investment that earns a risk premium. You have not exchanged your capital with an expectation of earning a return. You might hope that your acquisition rises in value and you earn a return, but hope is not a basis for a risk premium.
Consequently, activities that have no risk premium in an inefficient market are classified as speculation.
We arrive at the following summary.
A Language to Describe Investing
Most disagreements around investments really center around whether a market is, or is not, efficient, or whether an investment earns, or does not earn, a risk premium. Once you de-tangle this ‘meta’ analysis then all becomes clear.
Let’s look at a few examples.
It’s tough to decide whether the Bitcoin market is efficient or inefficient. It probably ought to be efficient since all the transactions are available to all on the blockchain, but it seems that a very large proportion of bitcoins and bitcoin transactions are run by a very limited number of players. There is also a lack of oversight and checks and balances and a general level of shady non-transparent activities that lead me to put it in the ‘inefficient’ bucket. However it’s straightforward to conclude that Bitcoin has no risk premium. There is no reason you should expect to be paid for buying Bitcoins.
Proponents of Bitcoin will claim that it is the future and it will be widely adopted in the future and there is a finite supply, therefore you should buy now to capitalize on a future increase in value. However there is nothing in the transaction of exchanging US dollars for Bitcoins that comes with an expectation of future return. It’s simply speculation. Note this is different to investing in a startup company that might be launching Bitcoin ATMs. In this case feel free to lend to the company directors, or buy a stake in their enterprise. But in return you should expect a risk premium for your investment.
Long Maturity Treasury STRIPs
I wrote a couple of articles about investing in STRIPs. From my perspective US interest rates are pretty efficient and I don’t have an ‘edge’ or any special insights over the other market participants. Hence, I would only invest passively in those instruments. However, there are others with a stronger view on the direction of interest rates, or inflation, and so it makes sense for them under their paradigm to trade actively.
Dividend Paying Stocks
There are many strong adherents to dividend paying stocks. Personally I don’t discriminate in my stock portfolio between companies that pay dividends or not. Why? Because I believe the equity market is efficient enough so that any potential advantages of dividend stocks (to the extent that they might exist) would get reflected in the stock’s price. In other words by believing in efficiency I neatly sidestep the issue of whether dividend stocks are ‘better’, since if they were better the market would price them more highly and so their betterness would quickly erode. However if you don’t believe dividend stocks are an efficient market then we will forever be at logger-heads!
Real estate is a bit tricky.
If you buy a house or land in the hope that it appreciates then that is speculation. You may have special insight into the future value of that house/land; perhaps you know that the city will be building a subway out to the neighborhood and prices do not reflect this perceived value-add. But it’s speculation, there is no risk premium.
As discussed above rental properties do have a risk premium attached.
Property improvement is best to compare to an enterprise like a company. A company takes raw ingredients and turns them into something that has value and can be sold for profit. Similarly, house improvement takes a house, some materials, time, effort and expertise and turns it into a more valuable house that can be sold for profit. If you have $50 available for house improvement, then there is a risk premium there since you are essentially lending that money to Yourself House Improvement Inc. with the expectation of turning a profit.
Author Bio: I started actuary on FIRE as I did not see any actuaries taking a prominent role in the personal finance area and wanted to remedy a shortage of actuary jokes and write for those that appreciate rigor with fancy charts. In my regular day job I advise corporate US on investment and retirement strategies. I’m a qualified actuary, investment adviser and have a PhD in mathematics and reserve the right to have the occasional math post.