Most Investments are Actually Bad. Here's Why.

🌈 Abstract

The article discusses how the vast majority of investments, including bonds, stocks, and real estate, perform poorly for outside passive investors. It analyzes historical data to show that only a small percentage of investments account for most of the returns, while the majority underperform even basic assets like gold. The article then explores why these mediocre investments still make sense from the perspective of owner-operators and workers, and how leverage has been used to turn some of these investments into good ones for outside investors. Finally, it discusses how the changing financial landscape, with rising interest rates and geopolitical tensions, may diminish the effectiveness of the leveraged "financial blackjack" strategy that has been successful in the past few decades.

🙋 Q&A

[01] Historical Data on Investment Performance

1. What does the historical data show about the performance of different asset classes?

• The vast majority of investments in bonds, stocks, and real estate perform poorly for outside passive investors.
• Only a small percentage of investments (e.g., 4% of stocks) account for most of the returns, while the majority underperform even basic assets like gold.

2. How have U.S. government bonds and gold performed over the long run?

• U.S. government bonds have underperformed gold over the long run, even though the U.S. dollar was the second-best performing currency over the past century.
• Holding gold has maintained purchasing power better than holding U.S. government bonds, due to the gradual dilution of the money supply.

3. What do studies show about the concentration of returns in the stock market?

• Multiple studies have found that a tiny percentage of equities (e.g., 4% of stocks) make up virtually all returns in equity markets, while the majority of stocks (over 50%) fail to outperform T-bills.
• The concentration of returns is even more extreme in non-U.S. equity markets.

4. How have historical real estate returns compared to gold?

• Unlevered real estate has generally underperformed gold in terms of price appreciation, even though it can provide rental income.
• Some high-performing real estate investments, such as in Manhattan or Silicon Valley, have done well, but significant amounts of real estate have also gone to zero in declining regions.

[02] Owner-Operators vs. Outside Passive Investors

1. Why do many mediocre investments still make sense to exist, even if they underperform for outside passive investors?

• These investments can still be valuable for owner-operators and workers, as they provide salaries, products/services, and other benefits, even if they don't generate strong returns for outside passive investors.
• The majority of businesses are not strong enough to provide good returns for outside passive investors after all expenses (including salaries) are considered.

2. How has leverage been used to turn mediocre investments into good ones for outside investors?

• Leverage allows investors to borrow abundant fiat currency at low rates and use it to buy scarcer assets like business equity or real estate, effectively shorting the fiat currency.
• This leverage-based strategy has been a key driver of wealth creation for large corporations, insurance companies, and other entities that have access to low-cost debt.

[03] The Changing Financial Landscape

1. How might the changing financial landscape impact the effectiveness of the leveraged "financial blackjack" strategy?

• The article suggests that the effectiveness of this strategy is likely to diminish as interest rates stop falling structurally and geopolitical tensions increase, leading to more barriers to the free movement of capital.
• The virtuous cycle of ever-lower interest rates, higher debt levels, and higher equity valuations may be coming to an end, potentially leading to a shift to a more challenging environment for this strategy.

2. What does the article suggest for passive investors in this changing environment?

• Passive investors should focus on businesses with durable competitive advantages or be very sensitive to valuations when buying mediocre companies, as the past four decades may not be a good dataset for forming strategies that will work in the next four decades.
• Hard assets like gold may become a more serious alternative for portfolio diversification, as the hurdle rate for stocks to outperform them is higher in an environment with fewer tailwinds.