At the end of Part II I mentioned that I’m not quite ready to begin investing because I still have a mortgage. You may be in a similar situation. However, this doesn’t mean that you or I should stop learning about investments and educating ourselves. Let’s continue this discussion.
So, what is it most worthwhile to invest in? This is a very complex question, and one that would be answered differently by nearly any investor out there. Let’s step back and look at investing from a broad perspective. What generates cash? Well, we have:
Let’s take a brief look at each type of cash-generating asset.
Private businesses have the most potential for cash generation, in my opinion. Businesses are the workhorse of any capitalistic system. They sell goods and services – anything from coffee makers to military aircraft. The fact that they are held privately allows for the owners to exert greater control over the business’ operations. Consequently, the owner(s) can make a handsome profit. Private businesses can require a lot of time, knowledge, and capital to become successful investments, especially when built from the ground up. John D Rockefeller built his Standard Oil empire by starting and growing a private business (which eventually went public). The chain of Aldi grocery stores is privately held.
Equity is just another word for ownership. Probably the most well known investment of this type is common stock, where shares (pieces of ownership) of a particular company are traded on a public exchange. These companies issue shares to raise money to expand their operations and to perform business. Investors form an opinion on how much each share of the company is worth, and that dictates the stock price. There are also other forms of equity investments, such as preferred stock and private equity investments. Preferred stock is basically the same as common stock except it comes with some extra benefits. Private equity investments are investments in private businesses that are not publicly traded. Equity-based securities generate cash for owners in the form of dividends paid out to shareholders, and also the appreciation of shares over time.
Debt-based securities most commonly come in the form of bonds. There are also things like tax-liens, notes, and certificates of deposit (CDs). These are all fixed income instruments, and basically rely on the re-payment of principal with interest. Governments, companies, and other entities issue bonds. Just like there is a stock market, there is a bond market where investors buy and sell debt, in order to collect interest income. When buying a bond, you agree to a set time frame for repayment. For example, if you bought a 5-year treasury bond from the United States government, you would receive interest payments throughout the five years, and then once the term is up, receive all your principal back. Bonds are a good hedge against deflation.
Ah, real estate. For a lot of investors, real estate is a great asset class because it is very tangible and more easily understood by your average person. There are a lot of ways to make money in real estate (flipping, wholesaling, etc), but from an investment perspective rental real estate is a popular option. Acquire a property, and then lease it out to a tenant for monthly cash flow. Additionally, unlike other investments, real estate can be highly leveraged to increase rates of return. Real estate is a good hedge against inflation.
The raw materials that make the world go round are called commodities. Think of things like oil, coffee beans, or copper. These things come directly from the ground and are then processed and utilized by businesses to provide different goods to society. If I struck oil in my backyard tomorrow or if I found certain minerals on my property, I could license the right to drill/mine for those natural resources. On Wall Street, there are commodities exchanges, where investors can trade based on the supply and demand of different goods.
A quick aside about gold – gold is probably the most well known commodity out there in the investment world. A lot of people love gold because it has been used as a medium of exchange since almost the beginning of time. The problem I have with gold is that it is very speculative. There is no way for me to know whether or not the supply or demand for gold will change tomorrow. Also, gold doesn’t really do anything. It doesn’t have intrinsic value. Since gold itself doesn’t cashflow, you can only make money from it through capital appreciation (selling for more than you bought it for).
Intellectual property can be an incredibly powerful wealth-building tool in today’s world. Every successful author, artist or inventor has utilized his or her intellectual property as a way of building wealth. This comes from royalties, which is basically the right to use an idea.
Thomas Edison founded General Electric using the vast portfolio of patents he acquired through his inventions. Because he had the exclusive rights to so many ideas, he was able to capitalize on them and build a powerful business. Every time Alicia Keys sells a song on iTunes, she gets a cut of the profits. The beautiful thing about intellectual property is that you can create an income stream off of one song, patent, process, or other system.
Phew, that was a lot. As you can see, it can get pretty overwhelming when you look at all the options out there. The cool thing is, people make money in each of those areas every day. In today’s world, there are so many paths to take. If you have expertise in a particular area already, it would be wise to look to that particular asset class as a place to invest in.
For me, I am leaning toward Equity-Based Securities, specifically Common Stock. My reasoning:
- It is a truly passive type of investment, even up-front, unlike a lot of other types of assets.
- As far as all asset classes go, stocks have the highest ROI over the long run, when compared with gold, bonds, or just sitting on cash. Of course, returns on intellectual property, commodities, private businesses or real estate could far surpass those in common stock. However, they all require lots of continual (or at least start up) effort, and great expertise within a particular field to be successful.
- With stocks, I can own a piece of an already successful business, and reap the benefits of its success.
- Unlike many other asset classes, it is very easy to diversify across many individual investments (for example, by using a broad-based index fund).
So, there it is. I like stocks because I can do a little bit of research up front and then read an annual report once a year to make sure my companies are still increasing profits. I don’t have to discover a gold mine, deal with tenants, or write a hit song. We’ll see in Part IV how to put this money to work in the stock market, and how to avoid some common pitfalls.
What do you think about each of these asset classes? Have you had great success/failure with any one in particular?