Stocks, Bonds, Real Estate and Small Businesses: Get Your Investment Basics Right
Let’s be honest about it. A job that pays well will provide enough to get you by and see you through rough times. You might make enough to send your kids through school and save up for retirement. You’ll eventually make enough to buy a home to raise your kids in and a car for the daily work commute. But a regular 9-5 job will never make you rich. For that, you need to face the risks and uncertainties of investment. The payoff is financial freedom, an aspiration that’s top of mind for citizens of the 21st century.
The dotcom bubble that burst just as the 20th century drew to a close, and especially the Great Recession of 2008 has scared off many would-be investors. Who wouldn’t be? Wall Street firms going under. Stock prices plummeting to record lows. Unemployment soaring to record highs. Falling real estate prices, rising foreclosures. This didn’t deter those who understood the nature of investments well. The resulting low prices made for a perfect buyer’s market and because over the long term standard investment instruments – stocks, real estate, and small business – are bound to bounce back, there was money waiting to be made. And make money they did.
Before you take the plunge you need to put your financial house in order to ensure that you’re high and dry when disaster strikes. The risk associated with investments can never be overemphasized.
Know your appetite for risk
Do believe that a bird in the hand is worth two in the bush? Or do you see money as a tool to make more money? Which one of these are you?
- Conservative – you’re not willing to take chances with your money, even if it means missing out on big gains.
- Semi-conservative – you’re willing to take small risks with enough information.
- Semi-aggressive – you have a bigger stomach for risk and you’re willing to take the chance of earning more money if the odds are in your favor.
- Aggressive – looking for every opportunity to make your money grow, even when the odds may be against you.
Here’s a quick quiz from Rutgers to help you test your tolerance for financial risk.
Set up an emergency fund
Make sure you have quick access to at least three months’ up to as much as six months’ worth of living expenses. You don’t want to end up on the street if your investments are wiped out. Also, you don’t want to sell off your investments because you need subsistence money. First things first, yes? Keep this emergency money in a money market fund, where there is a very low risk of your investment ever losing value because they’re invested in government securities, certificates of deposit, commercial paper of companies, or other highly liquid and low-risk securities. This will be your first baby step towards other more sophisticated investments.
Pay your debts off
Many personal finance experts believe that this, in itself, is the single greatest investment you can make. Instead of investigating ways of making more money, find out how you can stop losing money instead. Look at how much interest and service charges you have to pay off every month and compare this to the earnings you expect to make on an investment. You’ll might be surprised to find out that the cash going out can exceed cash coming in and paying off your debts might be the best high-return low-risk option. Consider this. If you have credit card debt with a 15% annual interest rate, paying off that debt is the same as putting your money to work in an investment with a guaranteed 15% tax-free annual return. Many investment options can’t beat that rate.
Monitor your savings rate
After all, you will need to accumulate money to invest. Your savings rate is the proportion of the money you didn’t spend out of your income. Doing quick mental math will give you a picture of your current savings. Are they practically non-existent? Very low? Substantial? During your most productive years, saving 10% of what you earn usually guarantees you at least 75% of the money you’ll need to retire without a substantial change in your standard of living. There are two ways of accumulating savings: (1) reducing spending, and (2) increasing income. The second option, especially if you already work hard and do long hours on the job, is quite difficult for most. Reducing expenses is the easier way to go. Remember this. Successful investors always live within their means. You will need to take stock of all your regular expenses and find out where you can cut spending without sacrificing too much of the lifestyle you think you deserve.
Invest in retirement funds
Not all people can survive the rough and tumble world of investments without the safety net provided by a retirement fund. This is, in fact, more than just a nest egg. It’s a form of investment that can help your money grow. Several excellent articles can help you understand the ins and outs of retirement funds: (1) Retirement 101: The Basics of 401(k), and (2) Retirement 101: How Much Do You Need to Save for Retirement? There are two main reasons for ensuring that you have this in place before taking the investment plunge. Many retirement fund options offer tax benefits, sometimes running up to many hundreds of dollars annually. Think of money saved from taxes as income. Also, setting up a retirement fund helps individuals focus on starting savings sooner.
Protect your assets
Few people will have enough bravado to invest everything they own, especially because there are other people who will be affected by their investment decisions. If something unforeseen and uncontrollable happens to your investments or to yourself, you need some form of protection. It’s always wise to investigate the insurance options available to you:
Major medical health insurance. You want a policy that pays for all types of major illnesses and major medical expenditures.
Life insurance, if loved ones depend on your income.
Disability insurance, because you need to survive injuries without having to sell off your investments.
Liability insurance, to protect your assets and net worth from lawsuits if you decide to invest in a small business. You’ll need adequate coverage from charges of malpractice, injury or negligence or you might end up with just the shirt on your back to show for many years of hard work.
Your investment options
Securing your financial foundations is a tall order in itself and getting these basics right might be all that you need to do. But, if after going through these you find that you still have the burning desire for wealth building and financial independence (and who doesn’t?), there are three paths you can take: financial markets (stocks , bonds and funds), real estate, and small business.
Financial markets in a nutshell
Most businesses start small, but as they grow bigger they will need more money (capital) to expand – to hire more people, buy new equipment, or set up the computer systems. Small firms may borrow from banks, but the bigger ones can choose two financial market instruments to raise the money they need — bonds and stocks:
Bonds are loan instruments that the company must pay back with interest. When a company issues bonds and you buy them, you’re essentially lending money to the company. The company doesn’t relinquish ownership to you, but they’re obliged to pay you back.
Stocks, on the other hand, are shares of ownership in the company. When you buy them, you essentially own a piece of the company. You only realize profit when you sell your stocks or when the company issues dividends for the shares that you own.
Companies can choose to raise funds either way. When the stock market is booming and the stock can fetch premium prices, stocks are an attractive option. Stocks are also favored by companies not comfortable with heavy debt. However, the regulatory requirements and paperwork necessary to offer stocks make this option burdensome. Also, when shares of a company’s stock are publicly held, this opens the company up to pressures from shareholders to turn in short-term profits which can harm their ability to plan for the longer term. Relinquishing ownership also means relinquishing part of the control the original owners have on the company’s direction.
Financial signposts to watch out for
If you decide to invest in financial markets, you will need to understand how companies behave in order to remain profitable so you can keep an eye on the rise and fall in value your investments. Always do your homework so you’re sure you are investing in a stock’s underlying value and not being blindly led by escalating market sentiment or irrational exuberance.
Innovation and Invention. Companies with a track record for coming up with new products that shake up the market and capture the consuming public’s fancy will have very animated share price activity. There’s a lot of money to be made in these companies, but only if you react quickly because the merest whisper can send prices tumbling down or wildly spiking up. Technology companies such as Apple and Google are a good example of this.
New markets. When a profitable company with established global brand recognition enters new territory, a spell of profitability usually follows. This is in part because there is an existing unmet demand for their products in these new markets. The global Starbucks invasion is a good example.
Vertical integration or related businesses. A company that controls its supply chain can weather shocks better. If it also makes the parts that go into its products, there is a smaller chance of delays in production. Samsung is one good example.
Brand equity. The profitability of companies that offer highly generic products such as cola, soap, and mayonnaise is often decided by which of the brands they own have more recognition and loyalty. The worth of a brand is quantifiable and conservative investors favor the stock of companies with established names.
Product cost and prices. Excellent products are just half of the story. Companies must know how to make them in the most efficient manner. They should also know how to price and position the products in the marketplace.
Competition. What a company does in anticipation of or as a reaction to competing brands and products is an important indicator of its long term profitability.
In exercising due diligence, you’ll also need to be aware of investment paths that you need to steer clear of. Check out Binary Options Trading: An All or Nothing Gamble? Some opportunities in financial markets are just not worth the risk.
Investing in Real Estate
Here’s the thing with stocks and bonds. Other than the decision to buy and sell, you’re almost a completely passive bystander. There’s nothing you can do to make stocks more attractive. Prices are what they are at the moment you decide to sell. This is definitely not the case with real estate. Here you scratch your itch for home improvement all you want, and profit handsomely from it. Also, unlike stocks and bonds, real estate is tangible. There’s way more satisfaction in pointing to a wonderful piece of property and saying it’s yours, over mentioning your shares of stock in this and that company at a dinner party.
Here are a few reasons why, despite property market busts, the attractiveness of real estate as an investment option is enduring:
The supply of land is limited. There is only a finite supply of land on which homes can be built. Populations continue to rise, and the demand for real estate will naturally increase. Building upwards in the form of highrises will only add to the value of the land.
Leverage. The typical initial investment for real estate is only a fraction of the total value but once the sale is executed you have control over the all of the value. If, for example, you buy property worth $150,000 and make a $30,000 down payment, if in three months the value appreciates to $180,000 you would have recouped 100% of your original investment.
Appreciation. This is the increase in the value of your property over time. You don’t have to pay tax on this profit until you decide to sell the property. Even then, you can always choose to roll over your profits to a similar investment so that it won’t be taxed.
Income. You can always choose to rent out the investment property to get a steady income stream, particularly on long-term leases. Some investors make enough income from the property to pay off the monthly mortgage, with enough to spare for maintenance and improvements, or even reinvestment.
Big future in small business
If you’re one among countless others who’ve been burned by bosses from hell, you’ve probably thought about what’s it like to be on the other side. If you owned a small business, that’s exactly what you’d be. Your own boss.
Before you do anything take this quick quiz: What’s your entrepreneurial IQ from entrepeneur.com. You’ll get instant results when you click submit. These are some of the characteristics that the quiz takes into account:
Initiative and persistence. Can you operate without a formal structure that tells you what to do? Will you exhaust all means to solve a problem?
Independence and self-control. Entrepreneurs often need to put in long hours alone in the early stages of the business. Can you function in this environment? Often there are no strict rules on what you can and cannot do. Can you maintain the necessary focus?
Willingness to make sacrifices. When you’re just starting out, the financial demands of your business may require you to give up the comforts and pleasures you’re accustomed to. Expensive vacations, luxury cars, or designer clothing will have to wait until your business is doing better.
Willingness to take rejection and negative feedback. You will have doubters, naysayers, and even detractors. If your family has no history of entrepreneurship you won’t get support even from the people you love. Can you take all of these without losing heart?
Ability to deal with risk and uncertainty. If you can’t handle these you’re better off with a regular paycheck from a 9-5 job.
You realize you can’t escape bosses (responsibility). Yes you might not have a boss that you report to directly but you still need to deal with difficult people (customers, suppliers, hardheaded employees). You must have the temperament to deal with this challenge
Starting a small business
As emphasized earlier, you’ll need money to make more money. There are many ways of securing the financing you need to start the business.
Bootstrapping. This is making do with whatever resources you have and operating strictly within your means. It’s pulling yourself up by the bootstraps in the truest sense. To be successful in this, you will need to have saved enough. You’ll also need to pare down your expenses to the barest minimum.
Borrowing. Business that are just starting out often find it difficult to borrow from banks. To be up for consideration, you will need a business plan, three years of financial statements and tax returns for the business and its owner, and projections for the business. If you don’t have these, consider other options.
- Credit unions can be a source of low-cost funds and are willing to make personal loans to members.
- You can take a loan out against your property. Real estate loans generally have lower and tax-deductible interest.
- Borrow from family and friends. This is one sure way to ruin relationships if you can’t pay them because your venture tanks. But if you borrow from them in the same manner that you do from financial institutions (with a signed letter of agreement stating the terms of the loan), and you do pay them back the goodwill that you reap can seal relationships for life.
Sell equity to angel investors. These very wealthy individuals are willing to bet that even if there’s a chance they’ll lose everything, the flipside is a substantial stake in what could potentially turn out to be a multimillion dollar enterprise.
Crowdsourcing/Kickstarting. This is the latest trend. It involves pre-selling your product to early adopters before you have the product on hand. You do this to raise enough funds so you can actually produce in the amounts demanded by your kickstarters. You have preproduction samples to show, and you can project delivery dates but everything will hinge on how many people will have faith to buy an idea that might never turn out to be workable in real life.
Now that you have a fair idea of good investment opportunities, it’s time to look at the dark side.
There are investment vehicles that are perfectly legal, but will take you nowhere. Caveat emptor.
Futures, Options, Precious Metals and Collectibles: Invest At Your Own Risk
is a fair warning to all prospective investors.