<Make Your Money Work: A Guide to Smart Investing Choices>
Written on
At some point, everyone toils for their earnings. The secret to accumulating wealth lies in having your money work diligently on your behalf.
This practice is known as investing, a fundamental aspect of personal finance.
With numerous investment options available, how do you determine where to put your money? I consider three essential factors when assessing potential investments:
How risky is it?
No investment is entirely devoid of risk. However, there’s a broad spectrum of risk levels across various investment types.
The crucial question is: What’s the likelihood of losing all your capital? While other forms of risk exist, the worst-case scenario is paramount.
A solid investment should offer a low probability of total loss. This characteristic is what sets investing apart from gambling.
Is Investing in the Stock Market Gambling?
The distinction between investing, speculating, and gambling
How high are the potential returns?
One notably secure investment choice is placing your funds in a savings account. However, the returns are typically dismal.
Most banks offer interest rates below 1% annually (and I mean well below). Online banks like Ally might provide rates under 2% as of this writing.
Such rates are simply inadequate.
Historically, interest rates have hovered just above 2% annually. This year, they have exceeded that figure significantly.
If your investment fails to outpace inflation, it may seem like you’re gaining wealth when, in fact, you’re losing purchasing power. Consider this: Doubling your money means little if prices triple.
The higher the annual return on your investment, the better. Personally, I view a desirable investment as one that yields around 7% annually. While this standard is somewhat arbitrary, it’s the rate needed for your money to double every decade.
How passive is it?
Certain investments allow for a “set it and forget it” approach.
Others demand ongoing effort.
If given a choice, most would favor the former. However, being more active in your investments can sometimes yield greater financial rewards.
Applying the Three Criteria to “The Millionaire Makers”
There are numerous paths to becoming a millionaire. However, only three time-tested strategies consistently elevate ordinary individuals to millionaire status:
- Launching a business
- Real estate investments
- Stock market participation
While lotteries, professional sports, and cryptocurrency have also produced millionaires, these routes are unreliable for the average person. They may be more glamorous, but they are far less dependable.
This discussion centers on how to make your money work effectively.
Let’s delve into each of these three methods, which I’ve previously explored:
The Three Ways to Become a Millionaire
#### Without relying on luck
Starting a Business
Risk
Launching a business carries significant risk. You could potentially lose every dollar invested. Even worse, if you borrow funds to support your venture and fail to generate enough revenue, you could end up in the red.
Why did I categorize it as a moderate risk? Because there are strategies to manage financial risk. One such method is bootstrapping, where you reinvest profits back into the business instead of relying on loans. Nonetheless, there’s always a chance of losing your initial investment.
This highlights a key difference between starting a business and the other two methods: the potential to substitute “sweat equity” for actual capital. If you’re willing to invest time and effort, you can minimize the monetary investment needed to grow your business.
This can be advantageous or disadvantageous, depending on how you value your time and the returns generated.
In general, starting a business involves the highest risk due to the potential for your asset's value to plummet.
Returns
This is where entrepreneurship truly excels.
The potential returns are virtually limitless. While it may not be common, it is possible to establish a business that generates millions in profits annually. Your company might even attract a buyout offer from a tech giant for nearly $20 billion.
Passivity
While returns are a strong point for starting a business, the passivity factor is its Achilles' heel.
The initial effort required to launch a business is substantial and can be incredibly stressful. However, for those willing to work hard and accept higher risks, the rewards can be significant.
Over time, it’s feasible to build a business that operates independently or can be sold, but reaching that stage demands considerable effort.
Real Estate
Risk
Real estate entails a variety of minor risks, including:
- Difficulty in finding tenants
- Late rental payments
- Unexpected maintenance and upkeep costs
- Challenges in managing mortgage payments
However, a significant mitigating factor is owning a tangible asset that is unlikely to lose all its value. This isn’t an infallible safeguard; if forced to sell the property for less than your mortgage, you could incur losses exceeding your initial investment.
Why did I rate real estate as lower risk than starting a business?
- Real estate values rarely fall to zero, unlike business valuations.
- Generating revenue through real estate is generally easier; you simply need to find tenants.
Returns
Historically, real estate returns have been comparable to stock market returns.
However, skill plays a crucial role. With smart real estate investments, you can potentially outperform the stock market.
Much of this comes down to minimizing costs, particularly regarding the initial purchase price. As the saying goes, profit in real estate is made when you buy, not when you sell.
Passivity
Real estate investments are not as passive as stock market investments and can be nearly as demanding as running a business.
You might hire a management company to handle your property, but they will consume a portion of your profits. Alternatively, you may reach a point where you own enough properties to justify hiring a property manager, allowing for some passivity.
Overall, real estate ranks low on the passivity scale.
The Stock Market
Risk
Investing in individual stocks carries substantial risk. Conversely, investing in the entire market (via index funds) reduces risk significantly.
The most critical risk in investing is the chance of losing everything. If you invest in an index fund that encompasses the entire market, the odds of losing everything are exceedingly slim—only if every public company fails simultaneously. While anything is possible, the likelihood is minimal.
Even in a worst-case scenario, if all public companies went bankrupt, you would likely not lose everything. The companies would liquidate their assets, settle debts, and distribute any remaining value to shareholders.
When utilizing a passive investment strategy with index funds, the primary risk is known as sequence of returns risk. This concept refers to the market's fluctuations over time. Although the market generally trends upward, the timing of withdrawals can significantly impact your investment's longevity.
For a comprehensive exploration of sequence of returns risk and how to mitigate it through asset allocation, refer to this article:
How to Protect Your Wealth
#### Asset Allocation the Simple Way
Returns
The S&P 500, a leading benchmark for stock market performance, has delivered an average annualized return of approximately 10.5% since 1957. That’s quite impressive.
Naturally, the market experiences both upward and downward fluctuations. The annualized rate suggests that if you invested in the stock market since 1957, your current value aligns with a consistent 10.5% annual return.
A 10.5% return results in your money doubling approximately every seven years.
Despite the associated timing risks, the stock market has consistently surpassed our 7% return benchmark over extended periods.
Among the three millionaire-making methods, stock market investing typically yields the lowest returns.
Passivity
The stock market truly shines in terms of passivity.
Passive investing through index funds offers a nearly effortless approach—set it and forget it.
Once you establish your initial asset allocation, you can automate your investments through platforms like Fidelity or Vanguard. After that, minimal intervention is required.
You may need to periodically check your account for withdrawals or portfolio rebalancing, but overall, the investment will largely manage itself.
This attribute underscores why I believe the stock market is an excellent choice. If you’re unsure how to make your money work for you, selecting an investment that requires minimal time to understand and operates on autopilot is a great starting point.
Final Thoughts
Due to inflation, any money saved is essentially working against you. While maintaining an emergency fund is wise, the cash within is gradually losing value each year. To truly advance, it’s vital to learn how to make your money work for you.
Accumulating wealth through saving alone is challenging. It’s far easier to build financial security when your savings generate additional income.