The General Rule
Many people know the assertion that the best way to make a small fortune – is to start with a large one! But that is not the only way, or the best way.
Let’s review the three major categories of investment possibilities that Warren Buffett addresses in his recent Fortune magazine article, (2/27/2012 issue) then seriously discuss a strategy that absolutely works for amassing modest wealth. The entire exercise of investing, of course, is to delay the gratification of consuming purchasing power today, to obtain greater, after-tax purchasing power, in the future.
Three Categories of Assets
The three categories of investment possibility are –
1) Currency-denominated assets such as:
Bonds, Money-market Funds, Bank Deposits, etc.
2) Unproductive assets such as:
Gold, Silver, Diamonds or even Tulips.
3) Productive assets such as:
Businesses, Farms or Real Estate.
Buffett alleges that currency-denominated assets, though seen as least risky by many, in reality are the most risky, because of government politicians’ tendency to manipulate currency value (the inflation tax) for short-term political purposes.
Soon enough, the return on currency-denominated assets, after subtracting inflation and taxes, is zero, or close to zero. To quote Shelby Davis, “Bonds promoted as offering risk-free returns are now priced to deliver return-free risk.”
The most popular asset among non-productive assets is gold, seen as a safe haven by many today. But unproductive assets like gold never procreate. Please remember that one ounce of gold today is still one ounce of gold a thousand years from now, or even ten thousand years from now.
Both currency-denominated and non-productive assets are mostly popular because of fear, particularly assets like gold. Yes, the price of these types of assets may go up for a while, as the bandwagon for owning one or another particular non-productive or currency-denominated asset grows in popularity, but over time, bubbles always pop and price always fall back to earth.
Neither of these two asset categories ever meets the criteria of the real purpose of investment, which is to grow one’s future purchasing power, long-term. When bubbles burst as they inevitably do, Buffett observes, “investors who required a supportive crowd paid dearly for that comfort.”
The BEST Investing Strategy
May I point out, only investing in productive assets allows one to enjoy the possibility of increasing one’s future purchasing power for the long-term?
Specifically, the vast majority of one’s nest egg ought to be invested in productive assets, whether in owning real estate, and/or owning your own producing company, and/or owning equities (shares of productive companies), etc. Yet almost anyone would be lying if they said they knew exactly which productive assets to buy, when.
Because of this uncertainty, as well as short-term market and investment distortions, some portion of one’s investment pool should be cash, or S-T bonds, yet the vast majority of our investment pool needs to be invested in productive assets.
One important key to follow when investing is to diversify widely, thus lowering one’s total risk. Remember, the future is always uncertain and unknown, therefore risky.
May I explain what this might mean? When buying equities, spread investment risk around by investing in many companies and different industries. Whether your nest egg size is $20,000, $200,000 or $2,000,000, it is far less risky long-term to hold approximately the same dollar-size amounts of 40 or 50 companies in various industries, than investing your nest egg in only two or three firms. Yes, this approach puts an artificial ceiling on your short-term gains, but it also constructs a solid floor that keeps away irrecoverable losses.
The same logic applies to real estate. Owning several smaller rental units and/or apartment buildings and/or commercial buildings in different locations is far better than owning just one large piece of real estate in one location.
Though most of us cannot afford to buy entire productive enterprises, most of us can afford to own many smaller portions of productive companies. By diversifying our holdings, we lower our overall risk – portfolio theory and all that.
Lowering risk ought to be one of the biggest goals of prudent investing. Protecting one’s principal ought to be another. Read Benjamin Graham’s book The Intelligent Investor, (“if you read one book on investing, then read this one”, says the most successful investor who ever lived, Warren Buffett) before you really start investing. Then avoid as much as possible paying for other people to invest for you. Transaction costs often consume too much of the income generated by your wise investments – actually limiting the benefits of compounding interest.
The Nugget of Investing Wisdom
Due to compound interest (procreation working in your favor) following a prudent and diversified investment strategy will avoid catastrophic losses completely, protecting principle, lowering risk and growing your nest egg modestly throughout your life.
Let’s assume you are able to save 10% of your income, from age 25 to age 65. (There are many books written which discuss exactly how to save 10% of your income, which is not my topic today.) Say your annual income at this time is $48,000 a year. At a modest 7% annual return, your investment pool would grow to over $1 million. If you were able to average a 10% return, instead of 7%, that same $400 a month would then become $2.5 million! And an IRA can grow tax-free!
Over any 40-year period in the 20th century, the return on equities in America averages 10% plus. However much purchasing power a million dollars or 2.5 million dollars allows will undoubtedly grant you sufficient purchasing power from ages 65 to 95 to live comfortably, I suspect. Even major medical emergencies near the end of life most likely can be paid for out of your still mostly-compounding nest egg.
On the other hand, many people behave in ways that are risky indeed. Which leads me to one final piece of advice – never play the lottery. Winning the lottery requires overcoming odds of 5 million to 1 or worse. You have a much better chance of being struck fatally by lightning, which is a real, but unlikely risk that all of us bear.
Seize the day and choose to invest wisely and prudently in productive assets!