How Buffett sees the world

Warren Buffett divides investments into three main types

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The investing legend that is Warren Buffett recently outlined in a column for Fortune magazine how he categorises possible investments, and Fools would do well to understand this before putting money at risk.

First, a word about risk

And risk is the first thing to understand before going any further. To many in the investment industry, risk is equated with historical volatility, and is measured by beta, the amount the price of a share changes relative to a change in the overall market.

This might be acceptable for a statistician, but not for Buffett; to him, risk is the reasoned probability that an investment will cause its owner a loss of purchasing power over the contemplated holding period.

How the market chooses to value that asset in the meantime is of little consequence to him, as the market has a tendency to mis-price. Thus a volatile asset may be one that he considers low risk, while a stable asset may be hugely risky.

1. Currency-based investments

Currency-based investments, often referred to as 'fixed-income' investments, include bank deposits, government gilts and commercial bonds. They are generally thought of as safe, but "in truth they are among the most dangerous of assets. Their beta may be zero, but their risk is huge".

Even those that reliably pay their interest or coupons as they fall due have destroyed the purchasing power of investors, and are doomed to do so forever. The reason is inflation, and as government determines the ultimate value of money, 'systemic forces' will sometimes cause them to produce inflation.

And even a relatively modest rate of inflation in a trusted currency will compound significantly over the years, with the US dollar having lost a staggering 86 percent of its value since 1965. Investors would need to have been earning 4.3% interest tax-free annually from bond investments over that period to simply maintain their value.

In the real world, however, we do pay tax. Buffett takes a rate of 25 percent in his example, so the bonds would need to pay 5.7 percent gross just to keep up, which is coincidentally what continuous rolling of US Treasury bills produced over that 47-year period; considering any of that interest as income would have been a mistake.

"'In God We Trust' may be imprinted on our currency, but the hand that activates our government's printing press has been all too human."

Over some periods, of course, the interest rate may compensate for inflation, but at current rates he sees no upside, and quotes an old saying from Wall Streeter Shelby Cullom Davis: "Bonds promoted as offering risk-free returns are now priced to deliver return-free risk."

2. Investments that will never produce anything

Unproductive assets, such as gold and tulips, "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".

This type of investment requires an expanding pool of buyers, who, in turn, are tempted because they believe the buying pool will expand still further and will desire the asset even more avidly in the future.

In the case of gold, buyers have a justified fear of paper money, for the reasons outlined above, and their investment thesis depends the ranks of the fearful continuing to increase.

And if you were to take all the gold in the world — a 170,000-tonne cube, 68 feet per side, worth over $9 trillion — it would buy all the cropland in the US (producing an output of about $200 billion annually), 16 Exxon Mobils (NYSE: XOM) — each earning more than $40 billion annually — and still have a few hundred billion left over for spending money.

Those lands and companies will produce earnings every year for the next hundred years, while the block of gold will still be just a block of gold. Which would you rather have?

3. Investment in productive assets

These businesses, farms and property are all examples of productive assets, the sort that Buffett likes. Even businesses with heavy capital requirements can be better than the other two types of investment we looked at, but Buffett's preference is for businesses with the ability to deliver output that will retain its purchasing-power value in inflationary times while requiring a minimum of new capital investment.

"People will forever exchange what they produce for what others produce," he says, and a century from now, whatever type of currency we have, he believes people will be willing to exchange a couple of minutes of their labour for a Coca-Cola (NYSE: KO).

With all that in mind, what types of assets would you want to invest in?

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