Keeping Money in Lending Investments
In the first section of this chapter, “Growing Your Money in Ownership Investments,” I outline how you can make your dough grow much faster than the cost of living by using stocks, real estate, and small business. However, you may want or need to play it safer when investing money for shorter-term purposes, so you should then consider lending investments. Many people use such investments through local banks, such as in a checking account, savings account, or certificate of deposit. In all these cases with a bank, you’re lending your money to the bank.
Another lending investment is bonds. 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 corporate bond may pay you 4 percent interest annually 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 a company through one of its bonds that matures in, say, five years, and the firm doubles its revenue and profits over that period, you won’t share in its growth. The company’s stockholders are likely to 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.
Similar to bank savings accounts, money market mutual funds are another type of lending investment. Money market mutual funds generally invest in ultra-safe 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.
Understanding Risks and Returns
Who among us wants to lose money? Of course you don’t! You put your money into an investment in the hope and expectation that you will get back more in total than you put in. And you’d rather your chosen investments not fluctuate too widely in value. When it comes to investing, no concepts are more important to grasp than risk and return, which I explain in this section.
Realizing risks
The investments that you expect to produce higher returns (such as stocks) fluctuate more in value, particularly in the short term. However, if you attempt to avoid all the risks involved in investing, you probably won’t succeed, and you likely won’t be happy with your investment results and lifestyle. In the investment world, some people don’t go near stocks or real estate that they perceive to be volatile, for example. As a result, such investors often end up with lousy long-term returns and expose themselves to some high risks that they overlooked, such as the risk of inflation and taxes eroding the purchasing power of their money.
You can’t live without taking risks. Risk-free activities or ways of living don’t exist. You can sensibly minimize risks, but you can never eliminate them. Some methods of risk reduction aren’t palatable because they reduce your quality of life.
Risks are also composed of several factors. Following are the major types of investment risks and a few of the methods you can use to reduce these risks while not missing out on the upside that investments offer:
Market-value risk: Although stocks can help you build wealth, they can also drop 20 percent or more in a relatively short period of time. Entering 2020, who was thinking about how a pandemic and the government’s response might impact stock prices? Then, in a few weeks, stocks slid more than 30 percent due to government-mandated economic shutdowns. Although real estate, like stocks, has been a rewarding long-term investment, various real estate markets get clobbered from time to time.
Individual-investment risk: A down market can put an entire investment market on a roller-coaster ride, but healthy markets also have their share of individual losers. Just as individual stock prices can plummet, so can individual real estate property prices. With lending investments, you have a claim on a specific amount of a currency. Occasionally, currencies falter. Most folks ignore this low frequency but very high impact risk when thinking about lending investments.
Purchasing-power risk: Inflation — which is an increase in the cost of living — can erode the value of your money and its purchasing power (what you can buy with that money). I often see skittish investors keep their money in bonds and money market accounts, thinking that they’re playing it safe. The risk in this strategy is that your money won’t grow enough over the years for you to accomplish your financial goals. In other words, the lower the return you earn, the more you need to save to reach a financial goal. As a younger investor with so many years and decades of investing in your future, you need to pay the most attention to the risk of generating low returns.
Liquidity risk: Some investments are more liquid (how quickly an investment can be converted to cash) than others and more readily sold at fair market value on short notice. Bank savings accounts have no real liquidity risk. A real estate investment, by contrast, takes time and money to sell, and if you must sell most real estate quickly, you’ll likely get a fair amount less than its current full market value.
Career risk: In your 20s and 30s, your ability to earn money is probably your biggest asset. Education is a lifelong process. If you don’t periodically invest in your education, you risk losing your competitive edge. Your skills and perspectives can become dated and obsolete. Although that doesn’t mean you should work 80 hours a week and never do anything fun, it does mean that part of your “work” time should involve upgrading your skills.
Managing risks
Throughout this book as I discuss various investments, I explain how to get the most out of each one. Because I’ve introduced the important issue of risk in this chapter, I would be remiss if I also didn’t give you some early ideas about how to minimize those risks. Here are some simple steps you can take to lower the risk of investments that can upset the achievement of your goals:
Do your homework. When you purchase real estate, various inspections, for example, can save you from buying a money pit. With stocks, you can examine some measures of value and the company’s financial condition and business strategy to reduce your chances of buying into an overpriced company or one on the verge of major problems.
Diversify. Placing significant amounts of your capital in one or a handful of securities is risky, particularly if the stocks are in the same industry or closely related industries. To reduce this risk, purchase stocks in a variety of industries and companies within each industry. Even better is buying diversified mutual funds and exchange-traded funds. Diversifying your investments can involve more than just your stock portfolio. You can also hold some real estate investments to diversify your investment portfolio. If you worry about the health of the U.S. economy, the government, and the dollar, you can reduce your overall investment risk by also investing overseas so that you have a globally diversified portfolio of stocks. Most large U.S. companies do business overseas, so when you invest in larger U.S. company stocks, you get some international investment exposure. You can also invest in international company stocks, ideally through funds.
Minimize holdings in costly markets. Although I don’t believe that most investors can time the markets — buy low, sell high —