#34: My favourite way to think about investing, part 4: betting beyond the basics

Welcome to the Idiot Money newsletter. The newsletter that gets the basics sorted first.
This week: becoming wiser with money by understanding that alternative investments are more spthecial than special.
This is part 4 in a series. See also parts 1, 2, and 3. For a ton of reasons, this is a fleshing out of the grounding framework we’ve been building up, and not direct investment advice: inspiring thinking, not doing it for you. The only direct advice of any sort you should ever take from a newsletter is not to take any direct advice from anyone speaking to more than one person at once.
Betting on investment options beyond the basics can be worth a punt, but please gamble a little more responsibly, and a hell of a lot more thoughtfully than most who place such bets do.
So far, we’ve seen that:
All investments are gambles: you put aside something now in the hope of getting back something better later. Every use of your resources, be it labelled a ‘purchase’, an ‘investment’, or even ‘yet another bloody meeting’ is an investment – swapping potential stuff for an actual thing in the hope life is better with the actual than the potential.
The first and most important thing about gambling is that it’s about odds, not outcomes. Your long-term success comes not from picking winners, but from spotting mispriced percentages.
The starting point for choosing an investment strategy is to ask: ‘if all investments are gambles, what am I betting on?’ A bet on the value of the world’s companies growing in value is basically a bet on capitalism. It’s far easier to start by justifying deviations from this bet than to wonder which of a million other bets to make.
So what about those deviations? We’ve already looked at deviations within the confines of companies and countries that want to raise money in public somehow. What about deviating beyond the ‘equity’ universe? The three most commonly considered options are:
cash;
property; and
‘alternatives’ (including hedge funds, commodities, collectibles, and crypto).
Start-up companies owned by a friend or a bloke you met at a thing one time also deserve a mention. Things like structured products and other investment equivalents of processed ‘food’ do not.
When are these worth a punt that justifies deviating from your core bet on capitalism?
Cash
If you’re investing to beat inflation, as most are and all should be, cash obviously isn’t an ‘investment’ or a safe storehouse for your long-term money. But it does have a role to play, and if even one person reading this stops using cash returns as a benchmark when judging their cowboy adviser (please: don’t do this) then it’s worth a few words.
Cash has five possible roles:
Near-term spending – Don’t invest cash you are likely to spend in the next three years or so.
An emergency fund – Of between 3 and 12 months of spending (not income) depending on your financial and psychological circumstances. Just remember to actually use it when emergencies pop up.
Volatility damper – The defensive role in a portfolio is traditionally played by bonds (specifically big-country government, and not emerging-market / high-yield ones), but sometimes it’s easier to do it with cash.
Optionality – For seizing opportunities, be they investment-related or helping out in a crisis, for example.
Emotional insurance – Because it makes you ‘feel’ ‘safe’ when you can’t be bothered getting your head around the investment stats that would achieve the same thing without forgoing potentially millions in compounded returns.
Property
I could write a whole bunch of articles explaining why we’re so drawn towards investing in property (commercial or residential), the overblown benefits and hidden costs of doing so, and why so many so stubbornly refuse to see these. It’ll be in the book eventually. For now, just note that for a bunch of reasons, many of which you’ve probably already worked out yourselves, and many of which you probably haven’t yet, we’re misled into vastly overrating property as an investment option. It involves all sorts of big-ass, concentrated bets, and usually involves tons of time, admin, and borrowing money to make them.
Alternatives
Hedge funds. It’s quite easy to get quite cross when talking about hedge funds, especially when you consider how much pension and charity money is invested in them, so I’ll say nothing and just share three quotes instead:
If you had invested $1,000 in the shares of Berkshire Hathaway when Buffett began running it in 1965, by the end of 2009 your investment would have been worth $4.3m. However, if Buffett had set it up as a hedge fund and charged 2% of the value of the funds as an annual fee, plus 20% of any gains, of that $4.3m, $4.0m would belong to him as manager and only $300,000 would belong to you, the investor. – Terry Smith​
Between 1998 and 2010, investors made $9bn from investing in all listed hedge funds. In contrast, their managers (and their consultants) made a staggering $440bn – 98% of all profits. – Simon Lack, The Hedge Fund Mirage
"We earn half the performance of index funds, charge 30 times the fees of mutual funds, pay half the income tax rates of school teachers, have triple the ego of rock stars, and fewer disclosure requirements than the NSA. We're basically a conduit between public pension funds and Greenwich real estate agents." – Morgan Housel​
Commodities (e.g. gold and silver), collectibles (e.g. wine and art), and crypto. Not creating anything much more than mischief, these are almost all bets on the greater-fool theory. This could well be a bet you’re willing to make, and one that could pay off better than anything else in your lifetime. There are a lot of very great fools out there.
But in terms of having a place in a long-term portfolio that you’d quite like to live off for a long time, based on the data we have, there’s bugger-all economic rationale, and their role as risk-diversifier is better met by more accessible alternatives.
They could make for fun speculative bets, though, and if making such bets with whatever you can truly afford to lose makes you less likely to lose your head with the core part of your portfolio, then YOLO-ing away may be a smart bet (or at least a sort of FOMO insurance).
Start-up companies
The most lucrative form of betting, as any member of the Cabinet will tell you, is leveraging insider knowledge. And if you can leverage that with corrupt funds, all the better. Getting in on the ground floor of a start-up that successfully grows up is an almost unbeatable bet.
Lots of people even expect a major role of financial advisers to be sourcing such private investment opportunities. This is arguably as much about the prospective returns as it is about idiotically nurtured beliefs in rich-people circles that private is always better than private, and that being rich makes the rules of the investing game different, somehow.
Having discovered that having loadsa money doesn’t automatically make them happier, plenty of rich folk cling comically hard to the idea that their cash must at least open doors to the ‘best’ investments like it does the ‘best’ clubs.
This doesn’t happen, of course. Not least because any adviser worth taking advice from is going to struggle to evidence how any private investment opportunity: a) should be accounted for in the long-term planning you’re paying them for; and b) is a suitable short-term recommendation over and above the alternatives… the due diligence costs of a proper review are instantly prohibitive.
This isn’t to say such investments don’t have a role to play, but it’s the same one lottery tickets have: the benefits are almost 100% psychological, and if a payoff comes, great, it can – and should – change your life, but don’t plan for it.
Bet on boring
Done right, investing, like gambling, is boring. The major advantage of investing is that because you’re playing over such a long timeframe once you’ve done the boring bit (assuming you’ve done it wisely) you’re set for a decade or more.
Understanding the basics of what you are – and aren’t – betting on, and why you are and aren’t betting on them, is a necessary part of doing it wisely. It’s also crucial for being less stressed about money (in any of the ways we looked at in Idiot Money #33) and for not being ripped off if you buy advice.
And finally, more important than what to bet on beyond the basics is why you’d want to do so. If the return from the easily available, almost-zero money-, time-, and energy-cost option has left you wanting to risk additional money, time, and energy chasing something else, it’s at least a tiny bit possible that the problem you’re trying to solve has sod-all to do with the return.
#36: My favourite way to think about investing, part 5: cost-benefit investing

#33: The six financial stress responses: what's yours?

#35: The ABC of money, part 6: financial nobility, step 3

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Cash

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Alternatives

Start-up companies

Bet on boring