Are You Investing, or Just Rolling the Dice?
What is an Asset?
Above average height? An exquisite soprano signing voice? A gold bar? The idea of what constitutes an asset is different to different people, but when it comes to your finances there are certain things that should, and certain things that definitely shouldn’t, come into this category.
The only things that can really be classed as true investment assets are those than can produce an income. If you think about it, many, many assets do. A Buy-to-Let property pays you rent, a share portfolio pays dividends, money in the bank pays regular interest. Income from an asset is usually a lot more stable than its capital value, and is a key metric in working out the value of that asset.
There are a million and one ways to slice that pie, but essentially the more income an asset is likely to pay to investors, the higher the capital value. If you have a rental property that pays £100,000 a year, and another one that pays £5,000 a year, which do you think is going to be worth more? Same with shares. If Tesco is consistently making more profit and therefore paying consistently higher dividends to shareholders than Sainsbury’s, Tesco’s company value will likely be higher. Level of income is a huge driver of asset value.
But what about companies like Uber, Facebook or Twitter? The so called “Unicorns” of the tech world are prime examples of assets that can have insane valuations with little to no profit. What’s important here is that whilst these companies may not have been producing sizeable income to match their sky high market value, they promised the potential for future income. Let’s take Facebook shares as an example.
In the early days, Facebooks key focus was increasing the number of users. For those of us old enough to remember, for many years Facebook was very simple and had basically no ads. The idea behind this was to make the product as attractive as possible to people, grow it to become the world’s largest social network and then leverage all those users into revenue.
In the case of Facebook this has come to fruition, and they make billions in profits each year. You often see a similar initial trajectory in the mining and pharmaceutical sector. Prices for small mining or drug company stocks can skyrocket at the prospect of breakthrough that could provide massive future income. Oftentimes, once it becomes clear that this income isn’t likely to ever materialise, the share price plummets. All based on the expected future income.
The first bone of contention with this idea usually comes when we start to talk about…
The Family Home.
For many, this is the single largest purchase they will ever make and often takes significant sacrifice and long term planning to be able to achieve. At least a portion of the justification for this purchase comes from the fact that they are buying an “asset”. Especially for those who might be slightttllyyy over-extending themselves.
But unfortunately, a house you live in is not an asset. In fact, it’s a liability.
1. Doesn’t pay an income. Ok sure, maybe you’re getting some rent from an adult child still living at home (nice work by the way), but unless they are paying all the costs of the house then you’re still on the hook.
2. Costs you money to hold. If your boiler breaks, you need to pay for it. Pipe burst? Get your wallet out. Smashed window? Cash please! You are responsible for the maintenance and upkeep of your own place, and doing this doesn’t add any value to the property. Capital improvements like an extension or knocking down a few walls might add some value, but that brings us to our next point…
3. The value is always relative. Let’s say you buy your first house. It’s in a decent area, you wouldn’t mind staying here for the long term, but it’s a suburb or 2 away from where your dream houses are. Unfortunately, you just can’t afford to buy there. A few years pass, the market goes through an upswing and all of a sudden you’ve bagged an extra £100k in the value of your home. Amazing! Time to upgrade! Oh. Those dream houses you pined over originally have also gone up in value by £100k….or more.
This is the problem. We all need somewhere to live, so unless you are prepared to massively downsize or move into a worse area, the house itself is not going to increase in value in a way which is usable to increase your quality of life. Even the idea of downsizing is often better in theory than in practice. If you want to stay in the same ‘quality’ of area, a smaller house will be cheaper but generally not dramatically so. By the time you pay agents fees, moving cost, stamp duty and all the rest, there’s not likely to be as much left over as you thought.
Now don’t get me wrong, owning a house is a fantastic objective that everyone should strive for. It’s not just about the pounds and pence; it’s about having a place to call your own for the long term. A place you can paint walls, build gardens and put down roots. But it’s important to remember that the more you spend on your house the more of an ongoing financial liability it is going to be!
Rolling the dice
The last type of “asset” I want to cover are those that actually have no value. Ok, they do have a value but that value is based on the idea that some other sucker is going to pay you more for something than what you paid for it. This is also known as the Greater Fool Theory.
So what sort of assets are we talking about here. Let’s make a short list:
· Art
· Wine
· Classic cars
· Fancy watches
· Precious Gems and metals (some of these might get a slight pass)
· Cryptocurrency (Bitcoin!)
And I get it. If I had spent hundreds of thousands on these things, maybe even millions, I’d like to fool myself that they make a great investment too. The reality is, you might enjoy collecting them but if you want to receive a return on your capital, then you need to find a greater fool than you who will pay you more. Part of the problem is that with no income, these assets can’t really be valued properly.
Intrinsically, a Picasso is worth a few pounds. There’s some canvas and some oil (no idea if Picasso paints oil on canvas but you get the point). The reason they sell for millions of pounds is because someone woke up in the morning and decided that’s what they’d pay for it. Same with wine, same with cars, same with watches. Yes obviously there are different degrees of workmanship involved but at a certain point, that’s not what you’re paying for.
And yes, I have included Bitcoin! Again, it doesn’t pay an income, you need the price to go up for you to get a return and it’s bloody volatile to boot.
Now the reason why I’ve said that some precious metals get a slight pass, is because their change in value can be linked to something intrinsic. Gold is a prime example nowadays as it does have a variety of uses, particularly in the tech sector in devices like our iPhones. But generally speaking, most gems and precious metals rely on the greater fool theory to give you a return.
So what do I do now?
Try to think of assets as paying you a wage. For most people, the long term dream is to be able to have their investments (including pensions etc.) pay them an income whilst they spend their time doing what they want. The easiest way to make this happen is to focus on investments that pay a decent income.
When you are looking at whether something is a good investment, look at how much it can earn for you. Are these earnings stable? Are they sustainable? If not, what are they likely to do in the future? This then allows you to come back to the price you’ve got to pay for it and decide whether it’s worth it or not.
By all means, roll the dice if you want. Have a punt on bitcoin, buy a gold bar and stuff it under the bed, play a few hands of blackjack at the casino every now and then. Just don’t make picking up a lucky ace the cornerstone of your wealth creation strategy.
