Chapter 1
In This Chapter
Defining investing
Seeing how stocks, real estate, and small business build wealth
Understanding the role of lending and other investments
Knowing where not to put your money
In many parts of the world, life’s basic necessities — food, clothing, shelter, and taxes — gobble the entirety of people’s meager earnings. Although some Americans do truly struggle for basic necessities, the bigger problem for other Americans is that they consider just about everything — eating out, driving new cars, hopping on airplanes for vacation — to be a necessity. I’ve taken it upon myself (using this book as my tool) to help you recognize that investing — that is, putting your money to work for you — is a necessity. If you want to accomplish important personal and financial goals, such as owning a home, starting your own business, helping your kids through college (and spending more time with them when they’re young), retiring comfortably, and so on, you must know how to invest well.
It has been said, and too often quoted, that the only certainties in life are death and taxes. To these two certainties I add one more: being confused by and ignorant about investing. Because investing is a confounding activity, you may be tempted to look with envious eyes at those people in the world who appear to be savvy with money and investing. Remember that everyone starts with the same level of financial knowledge: none! No one is born knowing this stuff! The only difference between those who know and those who don’t is that those who know have devoted their time and energy to acquiring useful knowledge about the investment world.
Before I discuss the major investing alternatives in the rest of this chapter, I want to start with something that’s quite basic yet important. What exactly do I mean when I say “investing”? Simply stated, investing means you have money put away for future use.
You can choose from tens of thousands of stocks, bonds, mutual funds, exchange-traded funds, and other investments. Unfortunately for the novice, and even for the experts who are honest with you, knowing the name of the investment is just the tip of the iceberg. Underneath each of these investments lurks a veritable mountain of details.
An important part of making wise investments is knowing when you have enough information to do things well on your own versus when you should hire others. For example, investing in foreign stock markets is generally more difficult to research and understand compared with investing in domestic markets. Thus, when investing overseas, hiring a good money manager, such as through a mutual fund, makes more sense than going to all the time, trouble, and expense of picking your own individual stocks.
I’m here to give you the information you need to make your way through the complex investment world. In the rest of this chapter, I clear a path so you can identify the major investments and understand the strengths and weaknesses of each.
Observing how the world’s richest have built their wealth is enlightening. Not surprisingly, many of the champions of wealth around the globe gained their fortunes largely through owning a piece (or all) of a successful company that they (or others) built.
In addition to owning their own businesses, many well-to-do people have built their nest eggs by investing in real estate and the stock market. With softening housing prices in many regions in the late 2000s, some folks newer to the real estate world incorrectly believe that real estate is a loser, not a long-term winner. Likewise, the stock market goes through down periods but does well over the long term. (See Chapter 2 for the straight scoop on investment risks and returns.)
And of course, some people come into wealth through an inheritance. Even if your parents are among the rare wealthy ones and you expect them to pass on big bucks to you, you need to know how to invest that money intelligently.
Not everyone needs to make his money grow, of course. Suppose that you inherit a significant sum and/or maintain a restrained standard of living and work your whole life simply because you enjoy doing so. In this situation, you may not need to take the risks involved with a potentially faster-growth investment. You may be more comfortable with safer investments, such as paying off your mortgage faster than necessary. Chapter 3 helps you think through such issues.
Stocks, which are shares of ownership in a company, are an example of an ownership investment. If you want to share in the growth and profits of companies like Apple, you can! You simply buy shares of their stock through a brokerage firm. However, even if Apple makes money in the future, you can’t guarantee that the value of its stock will increase.
Some companies today sell their stock directly to investors, allowing you to bypass brokers. You can also invest in stocks via a stock mutual fund (or an exchange-traded fund), where a fund manager decides which individual stocks to include in the fund. I discuss the various methods for buying stock in Chapter 6.
However, I don’t think you should expect that you can “beat the markets,” and you certainly can’t beat the best professional money managers at their own, full-time game. This book shows you time-proven, non-gimmicky methods to make your money grow in the stock market as well as in other financial markets. I explain more about stocks and mutual funds in Part II.
People of varying economic means build wealth by investing in real estate. Owning and managing real estate is like running a small business. You need to satisfy customers (tenants), manage your costs, keep an eye on the competition, and so on. Some methods of real estate investing require more time than others, but many are proven ways to build wealth.
John, who works for a city government, and his wife, Linda, a computer analyst, have built several million dollars in investment real estate equity (the difference between the property’s market value and debts owed) over the past three decades. “Our parents owned rental property, and we could see what it could do for you by providing income and building wealth,” says John. Investing in real estate also appealed to John and Linda because they didn’t know anything about the stock market, so they wanted to stay away from it. The idea of leverage — making money with borrowed money — on real estate also appealed to them.
John and Linda bought their first property, a duplex, when their combined income was just $20,000 per year. Every time they moved to a new home, they kept the prior one and converted it to a rental. Now in their 50s, John and Linda own seven pieces of investment real estate and are multimillionaires. “It’s like a second retirement, having thousands in monthly income from the real estate,” says John.
John readily admits that rental real estate has its hassles. “We haven’t enjoyed getting calls in the middle of the night, but now we have a property manager who can help with this when we’re not available. It’s also sometimes a pain finding new tenants,” he says.
Overall, John and Linda figure that they’ve been well rewarded for the time they spent and the money they invested. The income from John and Linda’s rental properties also allows them to live in a nicer home.
I know people who have hit investing home runs by owning or buying businesses. Unlike the part-time nature of investing in the stock market, most people work full time at running their businesses, increasing their chances of doing something big financially with them.
For example, a decade ago, Calvin set out to develop a corporate publishing firm. Because he took the risk of starting his business and has been successful in slowly building it, today, in his 50s, he enjoys a net worth of more than $10 million and can retire if he wants. Even more important to many business owners — and the reason that financially successful entrepreneurs such as Calvin don’t call it quits after they’ve amassed a lot of cash — are the nonfinancial rewards of investing, including the challenge and fulfillment of operating a successful business.
Similarly, Sandra has worked on her own as an interior designer for more than two decades. She previously worked in fashion as a model, and then she worked as a retail store manager. Her first taste of interior design was redesigning rooms at a condominium project. “I knew when I did that first building and turned it into something wonderful and profitable that I loved doing this kind of work,” says Sandra. Today, Sandra’s firm specializes in the restoration of landmark hotels, and her work has been written up in numerous magazines. “The money is not of primary importance to me,” she says. “My work is driven by a passion … but obviously it has to be profitable.” Sandra has also experienced the fun and enjoyment of designing hotels in many parts of the United States and overseas.
Most small-business owners (myself included) know that the entrepreneurial life isn’t a smooth walk through the rose garden — it has its share of thorns. Emotionally and financially, entrepreneurship is sometimes a roller coaster. In addition to the financial rewards, however, small-business owners can enjoy seeing the impact of their work and knowing that it makes a difference. Combined, Calvin’s and Sandra’s firms created dozens of new jobs.
Besides ownership investments (which I discuss in the earlier section “Building Wealth with Ownership Investments”), the other major types of investments include those in which you lend your money. Suppose that, like most people, you keep some money in your local bank — most likely in a checking account but perhaps also in a savings account or certificate of deposit (CD). No matter what type of bank account you place your money in, you’re lending your money to the bank.
As I discuss in more detail in Chapter 7, you can also invest your money in bonds, another type of lending investment. When you purchase a bond that has been issued by the government or a company, you agree to lend your money for a predetermined period of time and receive a particular rate of interest. A bond may pay you 6 percent interest over the next ten years, for example.
An investor’s return from lending investments is typically limited to the original investment plus interest payments. If you lend your money to Apple through one of its bonds that matures in, say, ten years, and Apple triples in size over the next decade, you won’t share in its growth. Apple’s stockholders and employees reap the rewards of the company’s success, but as a bondholder, you don’t; you simply get interest and the face value of the bond back at maturity.
Cash equivalents are any investments that you can quickly convert to cash without cost to you. With most checking accounts, for example, you can write a check or withdraw cash by visiting a teller — either the live or the automated type.
Money market mutual funds are another type of cash equivalent. Investors, both large and small, invest hundreds of billions of dollars in money market mutual funds because the best money market funds historically have produced higher yields than bank savings accounts. (Some online banks offer higher yields, but you must be careful to understand ancillary service fees that can wipe away any yield advantage — see Chapter 7 for more information.) The yield advantage of a money market fund over a savings account almost always widens when interest rates increase because banks move about as fast as molasses on a cold winter day to raise savings account rates.
Why shouldn’t you take advantage of a higher yield? Many bank savers sacrifice this yield because they think that money market funds are risky — but they’re not. Money market mutual funds generally invest in ultrasafe things such as short-term bank certificates of deposit, U.S. government-issued Treasury bills, and commercial paper (short-term bonds) that the most creditworthy corporations issue.
Another reason people keep too much money in traditional bank accounts is that the local bank branch office makes the cash seem more accessible. Money market mutual funds, however, offer many quick ways to get your cash. You can write a check (most funds stipulate the check must be for at least $250), or you can call the fund and request that it mail or electronically transfer you money.
Suppose you think that IBM’s stock is a good investment. The direction that the management team is taking impresses you, and you like the products and services that the company offers. Profits seem to be on a positive trend. Everything’s looking up.
You can go out and buy the stock. Suppose that it’s currently trading at around $100 per share. If the price rises to $150 in the next six months, you’ve made yourself a 50 percent profit ($150 – $100 = $50) on your original $100 investment. (Of course, you have to pay some brokerage fees to buy and then sell the stock.)
But instead of buying the stock outright, you can buy what are known as call options on IBM. A call option gives you the right to buy shares of IBM under specified terms from the person who sells you the call option. You may be able to purchase a call option that allows you to exercise your right to buy IBM stock at, say, $120 per share in the next six months. For this privilege, you may pay $6 per share to the seller of that option (and you’ll also pay trading commissions).
If IBM’s stock price skyrockets to, say, $150 in the next few months, the value of your options that allow you to buy the stock at $120 will be worth a lot — at least $30. You can then simply sell your options, which you bought for $6 in the example, at a huge profit — you’ve multiplied your money five-fold!
Futures are similar to options in that both can be used as gambling instruments. Futures, for example, can deal with the value of commodities such as heating oil, corn, wheat, gold, silver, and pork bellies. Futures have a delivery date that’s in the not-too-distant future. (Do you really want bushels of wheat delivered to your home? Or worse yet, pork bellies?) You can place a small down payment — around 10 percent — toward the purchase of futures, thereby greatly leveraging your “investment.” If prices fall, you need to put up more money to keep from having your position sold. (Note: Futures on financial instruments like stock market indices and interest rates are generally cash settlement rather than physical delivery, and they’re an increasingly large part of the market.) My advice: Don’t gamble with futures and options.
Over the millennia, gold and silver have served as mediums of exchange or currency because they have some intrinsic value and can’t be debased the way that paper currencies can (by printing more money). These precious metals are used in jewelry and manufacturing.
As investments, gold and silver perform well during bouts of inflation. For example, from 1972 to 1980, when inflation zoomed into the double-digit range in the United States and stocks and bonds went into the tank, gold and silver prices skyrocketed more than 500 percent. With precious metals pricing zooming upward again since 2000, some have feared the return of inflation.
The term collectibles is a catchall category for antiques, art, autographs, baseball cards, clocks, coins, comic books, dolls, gems, photographs, rare books, rugs, stamps, vintage wine, writing utensils, and a whole host of other items.
Although connoisseurs of fine art, antiques, and vintage wine wouldn’t like to compare their pastime with buying old playing cards or chamber pots, the bottom line is that collectibles are all objects with little intrinsic value. Wine is just a bunch of old mushed-up grapes. A painting is simply a canvas and some paint that at retail would set you back a few bucks. Stamps are small pieces of paper, usually less than an inch square. What about baseball cards? Heck, my childhood friends and I used to stick these between our bike spokes!
I’m not trying to diminish contributions that artists and others make to the world’s culture. And I know that some people place a high value on some of these collectibles. But true investments that can make your money grow, such as stocks, real estate, or a small business, are assets that can produce income and profits. Collectibles have little intrinsic value and are thus fully exposed to the whims and speculations of buyers and sellers. (Of course, as history has shown and as I discuss elsewhere in this book, the prices of particular stocks, real estate, and businesses can be subject to the whims and speculations of buyers and sellers, especially in the short term. Over the longer term, however, market prices return to reality and sensible valuations.)
The best returns that collectible investors reap come from the ability to identify, years in advance, items that will become popular. Do you think you can do that? You may be the smartest person in the world, but you should know that most dealers can’t tell what’s going to rocket to popularity in the coming decades. Dealers make their profits the same way other retailers do: from the spread or markup on the merchandise that they sell. The public and collectors have fickle, quirky tastes that no one can predict. Did you know that Beanie Babies, Furbies, Pet Rocks, or Cabbage Patch Kids were going to be such hits?
Nothing is wrong with spending money on collectibles. Just don’t fool yourself into thinking that they’re investments. You can sink lots of your money into these non-income-producing, poor-return “investments.” At their best as investments, collectibles give the wealthy a way to buy quality stuff that doesn’t depreciate.