TL;DR: Most folks invest too much of their portfolio in publicly traded, highly liquid assets. Liquid assets like stocks trade at a premium due to the liquidity and option value that comes with a publicly traded asset. Once you’ve got six months of liquid investments / cash, you don’t need that liquidity ‘option’ as much and should consider allocating some of your money to less liquid investments like real estate, where you can generate higher returns, and cash flow to help you reach Ramen Retirement.
For the first decade of my investment life, I really only considered the public markets as a viable place to put my hard earned dollars. Only later did I realize how short-sighted that was. Yes, public markets can offer good investment opportunities, principally through low fee index funds that track the market. But what I know now is that investing in publicly traded securities comes at a price. There is a premium that people pay for highly liquid, tradable assets. That premium means your expected returns will generally be lower than investing in comparable assets that are less liquid.
Let me explain with an example: Real Estate Investment Trusts (REITs) are a great example of investors taking advantage of the liquidity premium. To do this they assemble a portfolio of real estate assets privately – this involves buying real estate directly. They then bundle that portfolio into a REIT structure that can be sold publicly. They take what were previously private investments and sell them to the public as tradable shares on public exchanges. In doing this, they are able to sell the portfolio of assets at a premium to what they paid. This is a fine example of the liquidity premium in action.
In short, investors are willing to pay a premium for the added convenience and liquidity associated with an asset that can be traded quickly and easily on a public exchange. To be clear, that level of liquidity has value. Liquidity gives you options, which are a great thing in life. It’s much easier to sell shares of a REIT, than it would be to sell the real estate assets underlying it. That optionality is valuable, particularly if you might need that money in the future, or might wish to move your money in and out of a particular asset class.
But… if you don’t expect to need that money anytime soon, and you’re comfortable making an investment you’ll be committed to for the next decade or more, you don’t really need that optionality. If that’s the case, why would you want to pay for it? When you buy highly liquid, public market investments, that’s what you’re doing – you are paying for added liquidity in the form of lower expected returns.
Reality is that most people need only a modest amount of liquidity. At the very least it’s a good idea to have roughly six months of expenses stored in low risk, liquid assets in case of emergency (job loss, sickness etc.). Six months should tide you through most things. Think you can’t get a job again in 6 months, or find some way of generating income? If need be, you can always turn to your retirement accounts for money as well. If you’re not making anything for more than six months, then your marginal tax rate for the year will likely be pretty low, which would make it worthwhile pulling that retirement money out anyhow. You’ll only pay a modest 10% penalty on the retirement money, which is likely less than your marginal tax rate when you are earning real money. So the truth is that you don’t need a ton of liquid investments.
Of course, diversification is another good argument to hold some amount of money in liquid public market equities. Holding low fee index funds is certainly a great way to get broad exposure to the growth of the economy at large. This is a good thing. Again, some amount of liquid, public market investments are a good thing.
Lastly, you might want to hold some assets in more liquid investments if you think you’ll need that money in the next year or so for a particular purchase – example, putting a down payment on a house.
But if you’re earlier in your career, earning good money now, and expect to be productive for the foreseeable future, there’s no reason you need to overdose on liquidity. If you don’t need the liquidity, it’s worth considering alternative investments that are less liquid, but offer the prospect of higher returns.
Some examples of alternative, less liquid investments include:
- Real estate
- Private equity
- Hedge funds
- Venture capital / angel investing
Of course, the only category I would recommend for most folks is real estate. I say this, primarily because those other investment vehicles are complex, and I generally stay away from investments I don’t understand. But beyond that, most of those other investment vehicles also require you to be an accredited investor. Unless you’re making more than $200K per year, or have a net worth (beyond your primary residence) of $1M or more, you won’t qualify. Furthermore, it’s difficult to even get access to those investments. Only the top funds in those categories truly outperform, and it’s unlikely you’ll be invited to invest alongside them. This means you might get left with only the mediocre investment managers who typically underperform. Not a great deal.
That leaves direct investment in real estate as the most viable option for most folks. It’s probably the most tried and tested way to access higher returns and generate long term, generational wealth. Within the world of direct investing there is a whole range of property types you can purchase:
- Single family residential
- Multi family residential
- Student housing
- Mobile home parks
- Office space
- Storage… the list goes on…
You also have the option of investing in any of those asset classes across any number of markets, from the coasts to the heartland, from big to small, the range of investment options is endless. The key with any real estate strategy is to choose an area of focus and go deep.
To put this all in perspective, typical stock market returns average 8-10% over the long term. Direct real estate investments have potential to yield 12-16% returns, with potential upside from market appreciation or inflation. Even a modest 12% return is 50% greater than an 8% return from public stocks. And that’s not even accounting for the beneficial tax advantages of real estate that allow you to defer tax in the early years, and roll your capital gains into ever larger investment properties.
The advantages are clear. If you’ve got more than six months expenses saved, and have the rest of your investments in public market stocks, you’re doing it wrong. You’re missing out on potentially greater returns, and the opportunity to generate passive cashflow to help you break free and reach Ramen Retirement sooner. If this sounds like you, and you want to make a change, drop me a line at email@example.com telling me about your situation and goals. I’d be happy to walk through your situation and help you think about the best way to start shifting some of your assets into less liquid investments that will pay off over the long term.
As always, enjoy the journey!