How To Invest

Investing is the most important and effective vehicle for producing wealth. Even when the economy is contracting and stock prices and real estate prices are dropping, there are ways to increase your net worth through investing. For most people, investing has become a necessity for building retirement savings, especially since the average lifespan continues to increase.

One way to invest is to seek passive income. This essentially means buying an asset that yields a stream of income. For example, you could buy a property and then rent it out.

The rent you collect is passive income. Another example is a fixed income investment such as a bond, where you are essentially lending a debtor money in return for the promise of receiving the principal and an agreed amount of interest payments for an agreed amount of time.

There are two main dangers with passive income investments. The first is that the income stream may not be reliable. For example, what if you buy property that you intend to rent out and suddenly demand for apartments in that area falls. You will probably be forced to lower the rent you are charging, or your apartment may sit empty for prolonged periods of time. With a bond, at least you know how much interest you will be paid, so your income stream will not fluctuate. However, depending on the bond, if the debtor goes bankrupt, the payment may not be received. High risk bonds are called junk bonds, and the investor has a high risk of not getting the principal back, however, these pay very high yields to compensate for the high risk.

The other danger with passive income is that the value of the income stream is diminished by inflation over time. For example, if you are a landlord, and you rent out an apartment for $1000 today, and 10 years from now, you are still charging $1000, then the income stream hasn't changed. But what if during that time, prices for other goods and services had doubled? That means that in 10 years, that $1,000 monthly income will only buy half as much stuff as it would today. Inflation is one of the reasons people need to invest just in order to maintain the purchasing power of the wealth they currently have. While there have been occasional instances where prices go down, or remain flat, these are very rare. Inflation has been more or less constant for the past 70 years, only varying in its degree of severity.

The greatest builder of wealth over history has been investing in the stock market. While there have been prolonged periods, even decades, where stocks have traded down or sideways, over the long term, stocks have consistently returned about 7-10% annually on average. This is a better performance than bonds or real estate. Of course, there are real estate investments that have produced greater returns, and plenty of stocks have gone to zero. So, of course you need to choose your investments wisely. But as an overall investment class, stocks are the best.

There are two main types of stocks, those that pay dividends and those that do not. Generally the stocks of more established companies with a strong positive cash flow will distribute some of their earnings in the form of dividends, providing a passive income stream to investors. However, the company has the right to discontinue or reduce dividend payments if it falls on hard times, so it is not the most secure source of income.

While a dividend can be nice, especially for retirees looking for income, many investors are more interested in the possibility of capital gains from stocks. This occurs when you buy a stock at one price, it rises and then you sell it. In order to make a profit, the gain in value must exceed what it cost to buy and sell the stock. Today, with discount brokerages available, the transaction costs are minimal, so it's not much of a concern unless you make a lot of frequent trades. Often, the stocks with the most spectacular capital gains are small companies that become big because of some competitive advantage.

For example, Microsoft started out as a very small company, and its stock has gone from less than $0.10 in 1986 to about $19 in 2009. That means that if you bought the stock in 1986 and sold it today, you would make about $190 for every dollar you invested. If you had invested $1,000, today it would be worth about $190,000. This demonstrates just how effective the stock market can be at building wealth. However, identifying stocks that rise as much as Microsoft is very difficult. Back in 1986, nobody knew just how big Microsoft would get in the future.

Most people don't need such massive capital gains when they are saving for retirement, especially in a tax sheltered investment vehicle. Even though 7-10% average annualized returns may not sound like much, if the money is left in place for a long time, the investments will grow a lot due to the magic of compounding returns. Of course, the value is constantly eroded by inflation, but over time, the gains typically outpace the rate of inflation by a very wide margin.

Other than real estate, stocks and bonds, there are other investments. For example, art and other collectibles such as antiques can be seen as an investment. Or buying precious metals like gold or silver. Even converting your currency into another country's currency is a form of investment, and its performance will depend on how the currencies trade against each other over time.

When economic times are bad and stock markets are declining, gold and other precious metals are often a good investment. There are also more complex investment vehicles that profit from a decline in stock prices. For example, exchange traded funds or ETFs that short sell stocks. You can buy ETFs that short sell financial stocks, real estate, or other areas of the economy and the ETFs will rise in value as the underlying stocks drop. Or you can short sell individual stocks and make money if they fall. However, the potential loss from short selling is unlimited, which means that it is a very dangerous investment. A safer way to profit from a falling stock is to buy put options. These investment vehicles are time based, so the stock has to drop within your chosen timeframe and according to your price targets. However, the most you can lose is your entire initial investment, which makes it safer than short selling.

Investing can be very complex, or it can be as simple as buying a home or buying and ETF that tracks the broader stock market indices. However, even deciding on your asset mix in your investments may require a professional opinion. It is a good idea to have an investment advisor, unless you have a background in personal finance, or feel comfortable learning all you need to know from web based financial advice.