What Assets are Out There?
The good news is that you have a lot of different investment options. The bad news is, once again, that you have a lot of different options. The sheer volume of choices available to you can be a distracting factor, so you need to develop some clarity to make informed choices. The following will explain the advantages and disadvantages inherent in several of the most common kinds of assets you may want to invest in.
Cash is one of the most common kinds of investments out there. On the positive side, cash provides the ultimate liquidity. When you store your money in investments such as your checking account, a certificate of deposit or a money market fund, you have a reasonably high level of access to it. You can access money from your checking account at an ATM or even electronically in seconds. In many cases, you can also get a rate of return that is stated for short periods and bears no risk of loss. If you ever lose your job or suffer some other kind of hardship, having a supply of cash on hand will help you stay afloat.
However, cash is far from perfect. In almost every kind of interest rate environment, cash typically has lower rates of return than other asset classes. Most bank accounts pay little to no interest; in a lot of cases, CDs and money market funds do not pay much better. While liquidity is important, you also need to make sure your interest rate is high enough to offset both the current rate of inflation and the taxes you pay on your interest, which are taxed as regular income. Earning money won't help you if your taxes and inflation eat all of your gains.
Once you've saved enough cash for six months to a year of expenses, you should start investing in other asset classes.
Stocks as an Asset Class
Another valuable component of a diversified portfolio is stock, the owner's equity in a company. Simply put, stocks are a form of ownership in a publicly traded company. Owning stocks allows you to experience extraordinary gains both through dividends and the potentially rapid increases in share price that stocks often experience. In a stock holding account, you can choose from a wide range of different stocks from different locations and industries. You can gain dividends that you can choose to either spend or reinvest in more shares of stock, further growing your wealth.
Stocks also have disadvantages. Owning shares of stock can be one of the riskiest investments, because stock prices can go downward as well as upward. On a daily basis, stocks are liquid but unpredictable. Companies can go bankrupt or shut down. If this happens, stockholders are at the bottom rung of any any company asset distributions during bankruptcy. Every other party gets paid back before equity holders. Stock selection can become very complicated, requiring a great deal of knowledge about the companies themselves in order to make informed choices. Stock investments also make financial planning tough, because there is no set schedule for their price appreciation. They fluctuate in price and cannot be counted on. Even common stocks that pay dividends are not required to pay them, and can halt dividend payments or cut them in times of need.
Bonds as an Asset Class
Bonds are another asset class. When you pay for a bond, you are essentially lending money to the company or to a government entity in exchange for the future return of your principal and the payment of interest in the interim. This interest is far safer than the dividends that some stocks pay, because it is contractually guaranteed. Even if the company issuing the bond goes bankrupt, you still have a reasonable chance to regain at least a portion of your initial investment, since the claims of bondholders come before the claims of stockholders.
However, bonds can fall victim to not paying enough to justify their investment. If you purchase a long- term bond in a low interest rate environment, you may find that as the economy picks up your bond is no longer covering inflation. Even if it is paying more than inflation, often the gains you could garner from other investments will dwarf the rate of return your bond is paying, which means you lost out on that opportunity. The set payouts of fixed-rate bonds make them vulnerable to inflation. The longer the duration, the more inflation risk a bond has.
Bonds with variable interest rates have properties that are more like cash than fixed-rate bonds. Such bonds include Treasury Inflation-Protected Securities (TIPS).
Real Estate as an Asset Class
Real estate is another type of investment you may consider adding to your portfolio. Real estate holdings consist of plots of land, houses or commercial structures, such as apartment buildings or strip malls. With a real estate portfolio you earn returns by avoiding paying rent or by renting out the property to a tenant and receiving rent for owning the structure. You can own and manage real estate investments directly or own them through investment vehicles. Real estate investment trusts (REITs) are common investment vehicles in this asset class that trades like stocks. Real estate tends to increase in value with inflation. In a lot of cases, rental rates can be adjusted with inflation.
Real estate also carries some disadvantages, however. You have to set your rental rate at a level that the market will bear or your property will sit vacant. In extreme cases, declines in local economies can push rents below profitable levels. You also need to protect and guard your property against theft and vandalism. Most landlords also find that human beings do not always pay their rent or take good care of the property. Even properly maintained, every component of a property will eventually need to be repaired or replaced as it wears out. Other costs like modernization of fixtures, landscaping, taxes and insurance make investment properties seem more like running a business than a passive investment. Unlike many other kinds of investments, a rental property is not liquid and can take a long time to sell if you need to get money out of it quickly.
Commodities as an Asset Class
Commodities are another important type of asset class you might want to consider. They are unlike many other investments, because they do not generate income or cash flows. Investors who buy commodities are betting that their prices will rise. Commodities are considered useful for hedging against inflation and for diversifying a portfolio of stocks, bonds and real estate. There are a couple of ways to invest in commodities: owning them physically and investing into baskets of them through a brokerage.
Theoretically, you could actually buy any commodity, including cattle, barrels of crude oil, bushels of wheat or bars of gold. Not all of them are practical to buy and store yourself. It is practical to buy gold and silver in the form of coins and bullion that you can keep in your home as "trophy investments." (You would need to insure them as part of your renter's or home insurance policy.) You should consider physical commodities if you find them to have value beyond their ability to be traded. You can actually use these possessions for something constructive, and that makes them valuable regardless of market prices. If you love inspecting your coins, you should consider direct ownership as a component of your portfolio.
For most commodities and most investors, direct ownership of the physical commodity would be impossible or a chore. You can also invest in commodities through owning them in baskets such as exchange-traded funds or by entering into a contract with a financial institution through an exchange- traded note. In some cases, these investment vehicles are extremely diversified and can help reduce the specific risks that an individual commodity may face by keeping several different kinds of commodities. They can also be traded through most brokerages, even brokerages that do not have the capability of trading individual commodities themselves. You can invest in exchange-traded-funds that either have physical holdings of your chosen commodities or that trade in commodities futures, a practice that most individual investors would be wise to avoid doing themselves. Consider an exchange-traded note or exchange-traded fund with low fees for your commodities allocation.
Human Capital: Your Job as an Asset
You work a lot of the time, and your job has the most important characteristic of being an asset: it pays money out to you. Your career is also like an investment, because you invest a lot of time and energy into it. In a sense, you are partnering with the company you work for. Because of this, you have to see your job as an asset and appreciate both its positive and negative traits as a component of your portfolio. When you think of your job this way, you can adjust your other investments to work better alongside it.
You can think about your job as a componet of your investment portfolio along with more "normal" assets like stocks and bonds. If your job prospects and your investments bear the same risks, you are not diversified. However, you can balance your job against your other investments so as to grow both your earning power and your stability. When these forces fall out of balance with one another, you run some potential risks that most people would rather not have. As rational investors, we don't take on risks without reason.
We strongly advocate carefully considering how you might spend money on your education or training as an investment, especially if you are young. To do so, you will need to research the cost and years of instruction you will need before you can start your career path, typical salaries in the career and the number of years you would like to spend in that line of work. The lower the cost education, the sooner you can start; the longer you can work in this career, the better it is as an investment. In some cases, the returns on education and training exceed returns on other kinds of assets.
Understanding Where Your Job Fits In
What kind of investment does your job act like? If your job is fairly stable regardless of the state of the economy, it behaves like a bond. Many government and education industry jobs are like this. If you are not likely to be fired or laid off due to the economy, you have a reasonably stable supply of income. You can balance this relative level of security by investing in stocks, which carry a higher level of potential for both risks and rewards. A stable job allows you to take more risks, because you can always fall back on that income if something goes wrong. In the case of dollar cost averaging, you can even put more money into stocks if their immediate value drops. If you have a career in an industry that does not go up and down with the stock market, your investment portfolio should be tilted toward stocks.
If your job is more dependent on a strong economy, you would be wise to put more of your portfolio into bonds. Commissioned sales jobs and financial industry jobs are highly dependent on the economy. Having a stable core of income is an important part of accumulating wealth, and bond investments tend to be more stable than stocks are. While the potential rewards are not as great, your job's more speculative nature makes you more likely to produce high income gains in the short run that you can then invest into your bond-heavy portfolio with a reasonable degree of safety. If you have a career in an industry that goes up and down with the stock market, your investment portfolio should be tilted toward bonds.
Direct Investment in Businesses: Buyer Beware
Many people fantasize about launching their own businesses or about being part owners of small private businesses. There can be many emotional rewards associated with these activities, and they often give people a deeper sense of satisfaction than investing in publicly-traded stocks and bonds.
However, we should not plan on new ventures to pay your bills. You cannot count on your new business or your investment in a private business venture as part of your personal financial plan. There are several reasons why:
Most new businesses fail.
Third party professionals do not regularly evaluate private investments that are not listed on a stock exchange. Often, you will be giving your money to a business owner or manager based on her information and claims about the future of the firm. This is a conflict of interest.
If you invest as a minority partner you may not be able to influence any decisions by firm management. They may not pay a dividend when you need them to.
Your ownership of the firm is illiquid. Unlike a stock, which can often be sold in seconds and cashed out in days, it may take years for you to find a buyer for your stake in a private company.
Starting a business or investing in a private venture can be a great experience, but don't count on it. These investments are not reliable investments that you should expect to pay out on a schedule.