Investable Universe

This is not investing advice. Seek a financial professional before making important financial decisions. This article is for informational purposes and should not be interpreted as a recommendation to buy/sell/or trade any security.



At the end of 2019 the total value of all financial assets stood at $543 Trillion. Financial Assets can be broadly grouped into five asset classes although there is some debate about what should count. Together they make up the investing universe and knowing your options should be the first step for any smart investor.

Debt is the largest asset class in the world...with a total value of $255 Trillion at the end of 2019. Debt is any form of loan or bond in which the borrower is expected to repay. This includes debt issued by governments, financial institutions, public companies, private businesses, and households. These debts include all variety of structures and purposes...everything from credit cards to government financing. Expected returns from debt are the easiest to forecast because future cash flows are mostly fixed at some rate. However, realized returns can come in substantially lower and even be negative if borrowers default or if inflation eats up the purchasing power of future cash flows. That means the yields (blue and red lines) need to be higher than inflation (yellow line) over the maturity of of the bond.

Real estate makes up the next largest asset class … with a total value of $217 trillion in the same year. Residential property makes up about 75% of the total value with the rest being commercial properties, farmland and any other physical lard or property. Returns on real estate are hard to estimate in large part because it often takes a lot of work. Returns also vary widely by location, location, location. Real estate returns are driven by price appreciation, cash flow, and time spent. Price appreciation is largely driven by inflation. Nominal returns for residential houses in the USA since the 1950s averaged 4.2%...but almost all this was inflation. Real returns were just 0.7%. Total returns might be higher or lower depending on the net cash flows received from tenants vs the cost of maintenance and managing tenants, and others costs.

Stocks of publicly traded companies amounted to $60 Trillion...a much smaller amount than many realize given the attention they get. Stock returns are extremely difficult to forecast short term but as a group are ultimately driven earnings. The chart below plots ten year average returns for stocks along with the inverse of the Cyclically Adjusted Price to Earnings ratio (CAPE). This ratio has a long name but is simple enough. CAPE equals the total market capitalization of stocks divided by average earnings over the past ten years. Averaging the past ten years helps smooth out earnings which are highly cyclical (hence the name). If we flip the CAPE so we have earnings in the numerator and price (market cap) in the denominator then we can see a pattern.


Turns out that investors make more money in stocks when they invest at cheaper prices. The correlation between the inverse of CAPE and future ten year returns was 58% from 1880 to 2010. The highest returns occurred when Treasury Bond yields are higher than average; which makes sense because stocks compete with bonds for investor demand so when the expected returns on one is high then the other should generally be priced accordingly so that neither is obviously cheaper. Note that inverse CAPE and Treasury Bond yields today are at 140 year lows (gasps from the crowd).

Precious metals make up an even smaller asset class with $11 Trillion total of above ground gold and silver at the end of 2019. All the gold in the world amounted to $10 Trillion, although only $195 Billion is in global exchange traded funds (“ETFs”) that you can buy with the click of a button. In comparison the total value of global Silver was around $1 Trillion. Drivers of precious metals are many, changing, and complex. Historical factors that have has some positive impact on gold prices include currency devaluations (inflation), volatility in the stock market (but not too much), high debt levels (but only if making headlines), scary events like 9/11, the creation of gold ETFs, upcoming US elections, and other things.

Gold and silver along with land are some of the oldest assets in history and so investors are largely drawn to them because they feel their value is intrinsic and dependable. That said...there is an opportunity cost to holding assets that don’t have cash flows and that is the return on lower risk assets like Treasury Bonds. When Treasury Bonds have high yields relative to inflation then investors in gold and silver usually lose. This is perhaps why the biggest and most consistent driver of precious metals is real interest rates. The chart below shows the price of gold relative to the expected real return on US Treasury Bonds. The “real” part is calculated by subtracting the expected ten year average inflation rate from the yield on ten year bonds. The inverse relationship is obvious...with gold rising rapidly in periods where real rates are falling. Today we have negative real rates...meaning that investors in Treasury Bonds are almost guaranteed to lose purchasing power over the next ten years. This makes it easier to justify buying shiny rocks...at least they look pretty.

Crypto-assets like Bitcoin is the last asset class we will discuss, the total global value of which stood at a tiny $190 Billion...with a “B” at the end of 2019. Crypto-assets are so small in part because they are so new, dating back to 2008 with the Bitcoin White Paper. The paper was written by Satoshi Nakamoto, an anonymous author that created the first decentralized blockchain called Bitcoin. Bitcoin is the best performing asset of the past decade...despite several bull and bear markets, some of which sent Bitcoin down to 10% of prior all time highs. Over 7,000 crypto-assets have been created since Bitcoin. Most provide no real value, but some solve some serious problems in the real world. What makes a crypto-asset value is that it is not controlled by anyone and is next to impossible to destroy.


There are essentially two types of crypto-assets...crypto-currencies and crypto-commodities. Crypto-currencies have essentially the same drivers as precious metals. They allow investors to own an asset that cannot be easily confiscated or destroyed. However, unlike gold and silver, crypto-assets like Bitcoin can be easily transacted almost instantly and at near zero cost with anyone in the world with a smartphone. Crypto-commodities derive their value from smart-contracts which are legal agreements that run on a blockchain and therefore do not require enforcement by a government or other third party. Both types of crypto-assets are most useful to people living in countries that lack a strong central government with reliable fiat money and enforcement of property rights and traditional contracts.


Crypto markets are so small their prices are largely driven by factors that are specific to the crypto market. Since Bitcoin was created it has gone through three bull and bear markets. These are obvious from the log price in the chart below. Each bear market lasted for about two years before investor interest started to return again. The biggest driver for Bitcoin is adoption and the fact that it still exists. Many large and reputable companies accept Bitcoin today and payment platforms like Cash App have made it very easy to use. Each day Bitcoin and other crypto-assets with valuable use cases like Ethereum grow in adoption in large part because of growing awareness and appreciation. But crypto-assets are still incredibly volatile...crashing without any obvious explanation quite frequently.

We did not include commodities in our investing universe but they deserve a special mention. If commodities were included they would make up a larger asset class then stocks. The largest commodity in most diversified commodity ETFs is Oil. Oil reserves amounted to 1.73 Trillion barrels at the end of 2019. At the current market price of $40 a barrel that comes out to $69.2 Trillion but no one knows how much of that will actually be brought to market and at what price. Other hard commodities the some investors sometimes hold include copper, nickel, platinum, and natural gas just to name a few. Commodities are assets but outside of gold and silver are almost entirely used for industrial purposes instead of as a store of value.


Other assets the some investors also consider include currencies, private equity and private debt. There are reasonable investing strategies here, but most retail investors do not have easy access to these securities. Currencies are a store of value, but generally lose value over time and so make tricky investments for those looking for a long term retirement portfolio which is really the focus here. Private equity and debt are legitimate financial assets, but often require considerable sums in order to gain exposure.


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We believe that a deep understanding of investable universe is a critical first step to smart investing. Think of these are the big pictures options that are available. Know the basics of the biggest drivers and risks associated with each asset class. Then start thinking about how to get True Diversification using asset classes that seem to provide Positive Skew.


https://www.intuitecon.com/post/true-diversification


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