Before even considering how to invest, you should already have a good understanding of how much income you have, how much you spend, how quickly your debt will be repaid and how much you save. Once your finances are in order, and good habits are in place, you are ready to invest wisely and speculate carefully.
While you are building up your capital, what you do with it has minimal impact, as long as it is safe. You could keep cash, put it in a savings account, buy mutual funds or ETFs. This discussion will focus on buying individual securities. In order to do that safely and efficiently, I suggest you need around $50,000. Before that, you will either pay too much in commissions, or be unable to buy enough different securities to diversify.
What does it mean to invest? Investing is the purchase of an asset that, over a period of time, will produce income for its owner. Let’s look at various investments, as examples. Savings accounts and term deposits are examples of loaning money to the bank, with the promise that the bank will pay interest until they repay your capital. Bonds (and debentures) are further examples of loaning out capital. Companies pay interest and promise to repay the principal at a future date. Rental real estate is an investment. The owner purchases an asset, the property, and then receives income in the form of rent or lease payments. A business is also an investment. The owner can launch a business or buy shares of an existing business. The business may own physical and intellectual assets. The owner then expects that the business will realise a profit when revenues exceed expenses. the profit may be paid to the owner in the form of income or dividends. Commodities, including gold are not investments. They are assets that produce no income, although the price may fluctuate. Betting on future prices is the definition of speculation.
Benjamin Graham explained it this way: “An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” Graham and Dodd’s Security Analysis (original 1934 edition).
I prefer not to directly own rental real estate only because of the involvement in time and labour. I own shares of businesses and I own real estate in a limited partnership, so that my investments are entirely hands off. However, I believe that we can benefit from viewing our investments the same way an owner would view a rental property.
It is important to have a comprehensive understanding of how your companies produce earnings. Shareholders are the owners of the company and profits that are not used to grow the company are distributed to owners, similar to how a landlord collects rent. Management has been hired by the shareholder owners to run our company. Just like with property management, if corporate management is either mismanaging our asset or taking too much income, it will not be possible for the owners to realise a reasonable return on our investment. Because it’s important to understand how the company produces income and how it is managed, it’s advisable to have a small portfolio of between ten and thirty companies.
Having a focused portfolio of companies makes it easier to stay abreast of developments, internal and external to the company, that can affect the future profitability of your investments. Understanding the earnings profile of your companies will make it possible to attach a value to your companies. This is beneficial when you are investing additional cash and want to determine which shares offer the best buying opportunity. Further, when the market price moves irrationally, such as with large trades or widespread panic, you will find it much easier to focus on the value of your companies, rather than the market price, and make wise decisions to either buy, hold or sell.
A good investment is a company that has consistent earnings and is able to grow those earnings over time. (It’s not more complicated than that, but that doesn’t mean it’s easy to find.) The company, however, has the choice to retain the earnings and use them to grow the company or to distribute the earnings as dividends. I prefer to buy companies that pay a dividend, because I find it more democratic. I then have the choice to keep the money, or reinvest it in the company, who can sell more shares if they require cash for growth. This is more common with mature, well-established companies. Small, newer companies generally have more room to grow and can more profitably employ their capital. Your preference may rest on how much you trust management to allocate excess capital and your own need for income from your investments.
Any company that does not yet have positive earnings is speculative. You are not buying earnings, but you are betting that there will be earnings in the future. Putting a price on unkown future earnings is much more difficult and is a major contributor to speculative bubbles, such as occured especially on the NASDAQ in 1999. Benjamin Graham points out the speculation is not wrong, but it is very different from investing. There are three major pitfalls with speculation: 1. do not confuse speculation with investment; 2. speculate only as a pastime, unless you have the knowledge and skill; and 3. only gamble with money that you can afford to lose.
The first step is to commit your money to an investment. You take some risk, but you will learn by doing. When your money is on the line, you are motivated to learn what you need to determine how to keep it safe and growing. The better your investment decisions, the greater your investment income, until it becomes greater than your savings rate. When your investment income equals your lifestyle spending amount, you will have achieved financial independence. After that, either work becomes optional or you can expand your lifestyle. Good motivation to invest wisely and speculate carefully.