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Investing has been described as the art of laying out money today in the hope of receiving more in the future. While I agree with the spirit of this oft-cited description, a more precise statement would incorporate the concept of purchasing power. Investing is not simply about laying out money today in the hope of receiving more in the future but the sacrificing of consumption today in the hope of consuming at least as much in the future. If investing is about transferring purchasing power from today to tomorrow, then investment opportunities should be evaluated by their ability to maintain and grow an investor's purchasing power over time.
Available opportunities
In today's financial landscape, there are myriad opportunities available to an investor. All these opportunities, however, fall into just three broad categories: cash, non-productive investments, and productive investments. Let's evaluate each of these categories in the context of our refined definition of investing.
'Cash' investments include interest-bearing investments such as savings accounts, CDs, money market funds and bonds in addition to paper currency and current account deposits. As a category, these investments have a terrible record of maintaining and growing purchasing power. The US dollar, for example, has lost 53% of its value over the last 30 years due to the corrosive effects of inflation. Short term bonds have not done much better. Holding a rolling investment in three-month US T-Bills would have yielded 2.64 per cent over the past 30 years compared to an inflation rate of 2.41 per cent.
Since governments ultimately determine the quantity of money available and the temptation to finance their spending by growing the monetary base is so great, cash investments are vulnerable to monetary devaluation. As a result, these investments do not provide an effective way to maintain an investor's purchasing power, making them a relatively poor choice among the categories I've highlighted.
Non-productive investments
This category includes assets such as fine art, rare coins and stamps, and, of course, gold. As the name suggests, these assets do not produce anything (in fact, most of them cost money to store). They derive their value from the belief that they can be sold for a higher price to ever more willing buyers in the future. A new entrant into this category are cryptocurrencies represented primarily by Bitcoin.
Investors in this second category are motivated by their fear of holding cash investments. As my explanation above should show, their fear is justified. From time to time, the level of fear becomes particularly pronounced, attracting more investors to the category and pushing prices higher. This, in turn, attracts even more investors, who see the rising prices as proof of the validity of the original investors' thesis. Prices can be driven up to incredible levels when a feedback loop like this takes hold of a market.
I believe that is currently the case with Bitcoin.
In the end, though, the value of any asset in this category, Bitcoin included, relies on its ability to continually pull new investors in. There are approximately 18.6 million mined Bitcoins at the moment. At an average price of $32,000 a coin, that amounts to a market value of $600 billion. Imagine, for a moment, that you purchased all 18.6 million Bitcoins for $600 billion. A 100 years from now, you would still have exactly 18.6 million Bitcoins. Any potential for capital appreciation relies solely on your ability to convince someone else to buy the coins for more than you paid or exchange goods and services worth more than $600 billion (in present-day dollars) for your stock of Bitcoins. Either way, the outcome is dependent on how that asset is perceived in the minds of others rather than any intrinsic value it possesses from being procreative.
Contrast this with the category of productive investments which includes farm land, real estate, and businesses. For $600 billion, you could, in theory, purchase every publicly listed business in Saudi Arabia, excluding Saudi Aramco. You would get a collection of 200 businesses that have produced $23 billion in profits over the last year. A 100 years from now, these businesses would have delivered billions more in profits and accumulated billions more in assets. Meanwhile, the virtual pile of digital coins will lie moribund on a hard disk somewhere.
While each of us may not have $600 billion to invest, the problem we face, as investors, is exactly the same. We have to determine which assets will provide us with the greatest chance of earning a return that will, at the very least, maintain our purchasing power in the future. Given a choice across the three major categories of investment, it should be clear that assets that produce goods and services people want will accrue permanent value to their owners while those that derive value from perception, rather than production, offer only fleeting promise.
Kunal Khanna is the Managing Director of Zugzwang Capital, a London based investment manager.
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