Warren Buffett - These are the safest assets in the long-term

Key takeaways at the end

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Investment possibilities are both many and varied. There are three major categories, however, and it’s important to understand the characteristics of each. So let’s survey the field.

1. Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. Most of these currency-based investments are thought of as “safe.” In truth they are among the most dangerous of assets. Their beta [technical measure of risk] may be zero, but their risk is huge. 

Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as the holders continued to receive timely payments of interest and principal.

This ugly result, moreover, will forever recur. Governments determine the ultimate value of money [or currency], and systemic forces will sometimes cause them to gravitate to policies that produce inflation. From time to time such policies spin out of control. [...]

High interest rates, of course, can compensate purchasers for the inflation risk they face with currency-based investments – and indeed, rates in the early 1980s did that job nicely. Current rates [in 2011], however, do not come close to offsetting the purchasing-power risk that investors assume. [...]

2. The second major category of investments involves assets that will never produce anything, but that are purchased in the buyer’s hope that someone else – who also knows that the assets will be forever unproductive – will pay more for them in the future. Tulips, of all things, briefly became a favorite of such buyers in the 17th century. 

This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce – it will remain lifeless forever – but rather by the belief that others will desire it even more avidly in the future.

The major asset in this category is gold. [...] Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end. What motivates most gold purchasers is their belief that the ranks of the fearful will grow. [...]

Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As “bandwagon” investors join any party, they create their own truth – for a while. [...]

3. Our first two categories enjoy maximum popularity at peaks of fear. [...] My own preference – and you knew this was coming – is our third category: investment in productive assets, whether businesses, farms, or real estate. Ideally, these assets should have the ability in inflationary times to deliver output that will retain its purchasing-power value while requiring a minimum of new capital investment. Farms, real estate, and many businesses [...] meet that double-barreled test.

Whether the currency a century from now is based on gold, seashells, shark teeth, or a piece of paper (as today), [...] people will forever exchange what they produce for what others produce. [...] I believe that over any extended period of time this category of investing will prove to be the runaway winner among the three we’ve examined. More important, it will be by far the safest. 

2011 Shareholder Letter

* Bold emphasis added

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Key concepts and takeaways:

• Productive assets: Assets such as businesses, farms or real estate all produce outputs and services that are exchanged. These outputs are exchanged at price levels prevailing around the time of the exchange, keeping the purchasing power. Two caveats: (1) Be careful with businesses that require large investments to produce outputs (e.g. some utilities). Those businesses might struggle to keep purchasing power because their capital expenditures will rise together with inflation. (2) What is wise at one price is dumb at another. Productive assets are not immune from bubbles.

• Unproductive assets: Return on assets such as commodities depends solely on the willingness of others to attribute a different price to that asset, however sound and sophisticated their reasoning might be.

• Currency-based assets: The real return on assets such as bonds is dependent on the value of the currency in which the asset is denominated. Inflation-protected bonds to be discussed separately.