Warren Buffett's Three Categories of Investments -- and the One That Matters Most

With Berkshire Hathaway's annual meeting right around the corner, now is a great time to revisit some of Warren Buffett's nuggets of investment wisdom he's shared with his shareholders throughout the years. One of my favorites is Buffett's discussion of the three different categories of investments, which sheds some light on why Buffett prefers stocks and entire businesses to any other asset class.

Image: Flickr user Blatant World.

Currency-denominated investmentsThe first category of investments includes those that are denominated in a given currency. Some popular forms of these include:

Money-market funds.
Bonds.
Mortgages.
Bank deposits.

These are generally thought of as "safe" -- after all, what could possibly go wrong when buying, say, a 30-year Treasury bond? However, Buffett pointed out in his 2011 letter to shareholders that just because there is little to no risk of losing one's principal doesn't mean an investment has "no risk." In fact, in the case of these investments, Buffett would argue the exact opposite.

The problem is that currencies tend to inflate over time, so these investments tend to produce little, if any, returns in real terms. In many cases, the actual return is even negative.

For example, Buffett points out that during the period from 1965 through 2011, the average return from a continuous rolling over of U.S. Treasury bills was approximately 5.7% on an annualized basis -- not bad, right? However, when you factor in income taxes and inflation, this isn't nearly as good as it sounds. Assuming a 25% tax rate, the effective yield falls to 4.3%. And, since inflation averaged exactly 4.3% during that time period, an investors' after-tax return would be effectively nothing.

Finally, it's important to point out that while these investments aren't Buffett's favorite, he does find them necessary. In fact, Berkshire's "cash" is primarily held in U.S. Treasury bills for their liquidity no matter what the economy is doing.

Image: Flickr user Bullion Vault.

Investments that don't produce anything, but could increase in valueThis category includes anything investors buy with the hopes that it will be worth more someday, but that doesn't produce anything. Gold is a perfect example -- it is a favorite defensive investment of many people, particularly those who are fearful that paper money will lose value rapidly over time.

Similarly to currency-denominated investments, things like gold do tend to keep up with inflation, but not much more. Plus, these investments are in danger of losing principle. The price of gold is essentially dependent on the demand of people who are fearful of other investments, and if this demand falls, basic economics tells us the price will, too.

Buffett's main problem with investments like this is that in 50 years, an ounce of gold will still be an ounce of gold. Meanwhile, an investment in 100 shares of a stock with a 3% dividend yield (assuming dividends are reinvested) would become nearly 440 shares after 50 years, and that multiplication in investment size is in addition to any price appreciation.

Coca-Cola is one of Berkshire's largest and longest-running stock holdings.

The winner: investments in productive assetsAs most investors know, Buffett prefers to invest Berkshire Hathaway's capital in businesses -- either by owning them outright, or in part through stock ownership. Buffett refers to this category as "productive assets," and feels that not only will these investments always produce the best returns over long time periods, but they'll also be the safest.

Specifically, Buffett loves productive assets because their value isn't determined by any currency, but their capacity to produce goods or services. These assets can grow their productivity over time by reinvesting profits, which in turn leads to higher ability to profit on a constant-currency basis.

In other words, companies such as Coca-Cola have an intrinsic ability to not only keep up with inflation, but to earn a return above and beyond inflation on a consistent basis. That's why Buffett prefers investing in businesses -- and why you should, too.

To sum it upWhile there's nothing wrong with holding currency-denominated investments in order to maintain some liquidity, or a relatively small amount of gold or similar non-productive asset, the bulk of most investors' portfolio should be invested in productive assets like stocks, businesses, and real estate. Over long periods of time, the other two categories are likely to do no better than to simply keep up with inflation, so for real growth, it's important to pick investments that can generate consistent inflation-adjusted returns.

The article Warren Buffett's Three Categories of Investments -- and the One That Matters Most originally appeared on Fool.com.

Matthew Frankel owns shares of Berkshire Hathaway. The Motley Fool owns shares of and recommends Berkshire Hathaway and Coca-Cola. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.